**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

** **

**FORM 10-Q**

 

**x**                              QuarterlyReport Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

** **

**For the quarterly periodended September 30, 2006**

** **

**or**

** **

**o**                                 TransitionReport Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

 

**For the transition periodfrom  *     * to  *     * **

** **

Commission File No. **001-10924**

 

**CLAYTON WILLIAMS ENERGY, INC.  **

(Exact name of Registrant as specified in its charter)

 

| **Delaware**                                  |   | **75-2396863**          |
|-----------------------------------------------|--------|-------------------------|
| (State or other  jurisdiction of              |   | (I.R.S. Employer        |
| incorporation or  organization)               |   | Identification  Number) |
| ** **                                    |   | ** **              |
| **6 Desta Drive, Suite 6500, Midland, Texas** |   | **79705-5510**          |
| (Address of  principal executive offices)     |   | (Zip code)              |

 

Registrant’s Telephone Number, including area code:**   (432) 682-6324**

** **

**Not applicable**

(Former name, former address and former fiscal year,if changed since last report)

 

Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theRegistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days.   x  Yes     o   No

Indicate by check mark whether the registrant is a large acceleratedfiler, an accelerated filer, or a non-accelerated filer.  See definition of “accelerated filer andlarge accelerated filer” in Rule 12b-2 of the Exchange Act.

| Large accelerated filer |   | o |   | Accelerated  filer |   | x |   | Non-accelerated  filer |   | o |
|-------------------------|--------|---|--------|--------------------|--------|---|--------|------------------------|--------|---|

 

Indicate by check mark whether the registrant is a shell company (asdefined in Rule 12b-2 of the Exchange Act).  o  Yes     x   No

There were 10,849,551 shares of Common Stock, $.10par value, of the registrant outstanding as of November 9, 2006.

 

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**CLAYTON WILLIAMS ENERGY, INC.TABLE OF CONTENTS**

# **PARTI.  FINANCIAL INFORMATION**

|           | ** ** | ** **                                                                                                    | ** ** | **Page** |
|-----------|------------|---------------------------------------------------------------------------------------------------------------|------------|----------|
| Item 1.   |       | Financial Statements                                                                                          |       |     |
|      |       |                                                                                                          |       |     |
|      |       | Consolidated Balance Sheets as of September 30, 2006  and December 31, 2005                              |       | 3        |
|      |       |                                                                                                          |       |     |
|      |       | Consolidated Statements of Operations for the three  months and nine months ended September 30, 2006 and 2005 |       | 5        |
|      |       |                                                                                                          |       |     |
|      |       | Consolidated Statement of Stockholders’ Equity for the  nine months ended September 30, 2006             |       | 6        |
|      |       |                                                                                                          |       |     |
|      |       | Consolidated Statements of Cash Flows for the nine  months ended September 30, 2006 and 2005                  |       | 7        |
|      |       |                                                                                                          |       |     |
|      |       | Notes to Consolidated Financial Statements                                                                    |       |     |
|      |       |                                                                                                          |       |     |
| Item 2.   |       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                   |       | 23       |
|      |       |                                                                                                          |       |     |
| Item 3.   |       | Quantitative  and Qualitative Disclosure About Market Risks                                                   |       | 37       |
|      |       |                                                                                                          |       |     |
| Item 4.   |       | Controls and  Procedures                                                                                      |       | 40       |
|      |       |                                                                                                          |       |     |
|      |       | **PART  II.  OTHER INFORMATION**                                                                         |       |     |
|      |       |                                                                                                          |       |     |
| Item  1A. |       | Risk  Factors                                                                                                 |       | 41       |
|      |       |                                                                                                          |       |     |
| Item  6.  |       | Exhibits                                                                                                      |       | 41       |
|      |       |                                                                                                          |       |     |
|      |       | Signatures                                                                                                    |       | 43       |

 

2

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**CLAYTON WILLIAMSENERGY, INC.CONSOLIDATED BALANCE SHEETS**(Dollars inthousands)

**ASSETS**
| ** **                                                 | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                 | ** ** | **2006**               | ** ** | **2005**              | ** ** |
| ** **                                                 | ** ** | **(Unaudited)**        | ** ** | ** **            | ** ** |
| CURRENT ASSETS                                             |       |                   |       |                  |       |
| Cash and cash  equivalents                                 |       | $                      | 8,746      |                  | $          | 5,935 |   |
| Accounts  receivable:                                      |       |                   |       |                  |       |
| Oil and gas  sales, net                                    |       | 24,616                 |       | 28,317                |       |
| Joint interest  and other, net                             |       | 9,359                  |       | 6,972                 |       |
| Affiliates                                                 |       | 1,452                  |       | 254                   |       |
| Inventory                                                  |       | 41,308                 |       | 43,753                |       |
| Deferred income  taxes                                     |       | 426                    |       | 439                   |       |
| Fair value of  derivatives                                 |       | 16,314                 |       | 191                   |       |
| Prepaids and  other                                        |       | 1,840                  |       | 2,581                 |       |
|                                                       |       | 104,061                |       | 88,442                |       |
| PROPERTY AND EQUIPMENT                                     |       |                   |       |                  |       |
| Oil and gas  properties, successful efforts method         |       | 1,188,416              |       | 1,037,862             |       |
| Natural gas  gathering and processing systems              |       | 18,049                 |       | 18,034                |       |
| Contract  drilling equipment                               |       | 47,855                 |       | —                |       |
| Other                                                      |       | 15,369                 |       | 12,396                |       |
|                                                       |       | 1,269,689              |       | 1,068,292             |       |
| Less accumulated  depreciation, depletion and amortization |       | (655,726               | )          | (594,225              | )          |
| Property and  equipment, net                               |       | 613,963                |       | 474,067               |       |
|                                                       |       |                   |       |                  |       |
| OTHER ASSETS                                               |       |                   |       |                  |       |
| Debt issue costs                                           |       | 7,992                  |       | 8,557                 |       |
| Advances to  drilling rig joint venture                    |       | —                 |       | 10,329                |       |
| Fair value of  derivatives                                 |       | 2,673                  |       | 127                   |       |
| Other                                                      |       | 14,229                 |       | 5,813                 |       |
|                                                       |       | 24,894                 |       | 24,826                |       |
|                                                       |       | $                      | 742,918    |                  | $          | 587,335 |   |

 

The accompanying notesare an integral part of these consolidated financial statements.

3

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** **

**CLAYTON WILLIAMSENERGY, INC.CONSOLIDATED BALANCE SHEETS(Dollars in thousands)**

**LIABILITIES AND STOCKHOLDERS’ EQUITY**
| ** **                                                                                                                                                                     | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                     | ** ** | **2006**               | ** ** | **2005**              | ** ** |
| ** **                                                                                                                                                                     | ** ** | **(Unaudited)**        | ** ** | ** **            | ** ** |
| CURRENT  LIABILITIES                                                                                                                                                           |       |                   |       |                  |       |
| Accounts payable:                                                                                                                                                              |       |                   |       |                  |       |
| Trade                                                                                                                                                                          |       | $                      | 69,935     |                  | $          | 59,861 |   |
| Oil and gas sales                                                                                                                                                              |       | 14,528                 |       | 18,236                |       |
| Affiliates                                                                                                                                                                     |       | 3,319                  |       | 2,857                 |       |
| Current maturities of long-term debt                                                                                                                                           |       | 8,011                  |       | 19                    |       |
| Fair value of derivatives                                                                                                                                                      |       | 29,630                 |       | 33,670                |       |
| Accrued liabilities and other                                                                                                                                                  |       | 5,650                  |       | 9,611                 |       |
|                                                                                                                                                                           |       | 131,073                |       | 124,254               |       |
| NON-CURRENT  LIABILITIES                                                                                                                                                       |       |                   |       |                  |       |
| Long-term debt                                                                                                                                                                 |       | 367,157                |       | 235,700               |       |
| Deferred income taxes                                                                                                                                                          |       | 44,782                 |       | 37,042                |       |
| Fair value of derivatives                                                                                                                                                      |       | 29,730                 |       | 49,705                |       |
| Other                                                                                                                                                                          |       | 22,868                 |       | 20,343                |       |
|                                                                                                                                                                           |       | 464,537                |       | 342,790               |       |
|                                                                                                                                                                           |       |                   |       |                  |       |
| COMMITMENTS AND  CONTINGENCIES                                                                                                                                                 |       |                   |       |                  |       |
| STOCKHOLDERS’  EQUITY                                                                                                                                                     |       |                   |       |                  |       |
| Preferred stock, par value $.10 per share,  authorized — 3,000,000 shares; issued — none                                                                             |       | —                 |       | —                |       |
| Common stock, par value $.10 per share, authorized —  30,000,000 shares; issued and outstanding — 10,849,551 shares in  2006 and 10,815,575 shares in 2005 |       | 1,085                  |       | 1,082                 |       |
| Additional paid-in capital                                                                                                                                                     |       | 107,431                |       | 107,108               |       |
| Retained earnings                                                                                                                                                              |       | 38,792                 |       | 12,101                |       |
|                                                                                                                                                                           |       | 147,308                |       | 120,291               |       |
|                                                                                                                                                                           |       | $                      | 742,918    |                  | $          | 587,335 |   |

 

The accompanying notes are an integral part of theseconsolidated financial statements.

 

4

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** **

**CLAYTON WILLIAMSENERGY, INC.CONSOLIDATED STATEMENTS OF OPERATIONS(Unaudited)(In thousands, except per share)**
| ** **                                   | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                   | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| REVENUES                                     |       |                                                 |       |                                                |       |   |   |   |   |
| Oil and gas  sales                           |       | $                                                    | 61,519     |                                                | $          | 65,739 |   | $ | 188,143 |   | $ | 190,536 |   |
| Natural gas  services                        |       | 2,905                                                |       | 2,572                                               |       | 8,890 |   | 7,703 |   |
| Drilling rig  services                       |       | 1,801                                                |       | —                                              |       | 2,175 |   | — |   |
| Gain on sales of  property and equipment     |       | 164                                                  |       | 16,832                                              |       | 916 |   | 18,911 |   |
| Total revenues                               |       | 66,389                                               |       | 85,143                                              |       | 200,124 |   | 217,150 |   |
|                                         |       |                                                 |       |                                                |       |   |   |   |   |
| COSTS AND EXPENSES                           |       |                                                 |       |                                                |       |   |   |   |   |
| Production                                   |       | 16,467                                               |       | 16,981                                              |       | 47,363 |   | 43,408 |   |
| Exploration:                                 |       |                                                 |       |                                                |       |   |   |   |   |
| Abandonments and  impairments                |       | 19,650                                               |       | 13,863                                              |       | 35,822 |   | 31,563 |   |
| Seismic and  other                           |       | 3,678                                                |       | 5,123                                               |       | 9,366 |   | 7,576 |   |
| Natural gas  services                        |       | 2,730                                                |       | 2,450                                               |       | 7,820 |   | 7,241 |   |
| Drilling rig  services                       |       | 1,157                                                |       | —                                              |       | 1,373 |   | — |   |
| Depreciation,  depletion and amortization    |       | 17,686                                               |       | 11,568                                              |       | 48,378 |   | 36,148 |   |
| Impairment of  proved properties             |       | 12,914                                               |       | —                                              |       | 12,914 |   | — |   |
| Accretion of  abandonment obligations        |       | 428                                                  |       | 291                                                 |       | 1,224 |   | 858 |   |
| General and  administrative                  |       | 3,086                                                |       | 5,483                                               |       | 11,405 |   | 11,135 |   |
| Loss on sales of  property and equipment     |       | 69                                                   |       | 100                                                 |       | 82 |   | 132 |   |
| Total costs and  expenses                    |       | 77,865                                               |       | 55,859                                              |       | 175,747 |   | 138,061 |   |
| Operating income  (loss)                     |       | (11,476                                              | )          | 29,284                                              |       | 24,377 |   | 79,089 |   |
| OTHER INCOME (EXPENSE)                       |       |                                                 |       |                                                |       |   |   |   |   |
| Interest expense                             |       | (5,328                                               | )          | (5,503                                              | )          | (14,628 | ) | (10,435 | ) |
| Gain (loss) on  derivatives                  |       | 26,734                                               |       | (28,766                                             | )          | 25,407 |   | (73,692 | ) |
| Other                                        |       | (1,583                                               | )          | 1,317                                               |       | (515 | ) | 2,413 |   |
| Total other  income (expense)                |       | 19,823                                               |       | (32,952                                             | )          | 10,264 |   | (81,714 | ) |
| Income (loss) before income  taxes           |       | 8,347                                                |       | (3,668                                              | )          | 34,641 |   | (2,625 | ) |
| Income tax (expense)  benefit                |       | (2,842                                               | )          | 1,628                                               |       | (7,754 | ) | 1,543 |   |
| Minority interest, net  of tax               |       | (156                                                 | )          | —                                              |       | (196 | ) | — |   |
| NET INCOME (LOSS)                            |       | $                                                    | 5,349      |                                                | $          | (2,040 | ) | $ | 26,691 |   | $ | (1,082 | ) |
| Net income (loss) per  common share:         |       |                                                 |       |                                                |       |   |   |   |   |
| Basic                                        |       | $                                                    | 0.49       |                                                | $          | (0.19 | ) | $ | 2.46 |   | $ | (0.10 | ) |
| Diluted                                      |       | $                                                    | 0.48       |                                                | $          | (0.19 | ) | $ | 2.38 |   | $ | (0.10 | ) |
|                                         |       |                                                 |       |                                                |       |   |   |   |   |
| Weighted average common  shares outstanding: |       |                                                 |       |                                                |       |   |   |   |   |
| Basic                                        |       | 10,850                                               |       | 10,810                                              |       | 10,847 |   | 10,800 |   |
| Diluted                                      |       | 11,205                                               |       | 10,810                                              |       | 11,220 |   | 10,800 |   |
|                                         |       |                                                 |       |                                                |       |   |   |   |   |

 

The accompanying notesare an integral part of these consolidated financial statements.

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** **

**CLAYTON WILLIAMSENERGY, INC.CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY(Unaudited)(In thousands)**

 
| ** **                                   | ** ** | **Common Stock** | ** ** | **Additional** | ** ** | ** **  | ** ** |
|----------------------------------------------|------------|-----------------------|------------|----------------|------------|-------------|------------|
| ** **                                   | ** ** | **No. of**       | ** ** | **Par**        | ** ** | **Paid-In** | ** ** | **Retained** | ** ** |
| ** **                                   | ** ** | **Shares**            | ** ** | **Value**      | ** ** | **Capital** | ** ** | **Earnings** | ** ** |
| BALANCE,                                     |       |                  |       |           |       |        |       |   |   |
| December 31, 2005                            |       | 10,815                |       | $              | 1,082      |        | $          | 107,108 |   | $ | 12,101 |   |
| Net income and total comprehensive income    |       | —                |       | —         |       | —      |       | 26,691 |   |
| Issuance of stock through compensation plans |       | 35                    |       | 3              |       | 323         |       | — |   |
| BALANCE,                                     |       |                  |       |           |       |        |       |   |   |
| September 30, 2006                           |       | 10,850                |       | $              | 1,085      |        | $          | 107,431 |   | $ | 38,792 |   |

 

The accompanying notes are an integral part of theseconsolidated financial statements.

 

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** **

**CLAYTON WILLIAMSENERGY, INC.CONSOLIDATED STATEMENTS OF CASH FLOWS(Unaudited)(In thousands)**
| ** **                                                                            | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                            | ** ** | **2006**                                            | ** ** | **2005** | ** ** |
| CASH FLOWS FROM  OPERATING ACTIVITIES                                                 |       |                                                |       |   |   |
| Net income  (loss)                                                                    |       | $                                                   | 26,691     |   | $ | (1,082 | ) |
| Adjustments to  reconcile net income (loss) to cash provided by operating activities: |       |                                                |       |   |   |
| Depreciation,  depletion and amortization                                             |       | 48,378                                              |       | 36,148 |   |
| Impairment of  proved properties                                                      |       | 12,914                                              |       | — |   |
| Exploration  costs                                                                    |       | 35,822                                              |       | 31,563 |   |
| Accretion of  abandonment obligations                                                 |       | 1,224                                               |       | 858 |   |
| Gain on sales of  property and equipment, net                                         |       | (834                                                | )          | (18,779 | ) |
| Deferred income  taxes                                                                |       | 7,754                                               |       | (1,465 | ) |
| Non-cash  employee compensation                                                       |       | 1,651                                               |       | 2,468 |   |
| Unrealized  (gain) loss on derivatives                                                |       | (42,684                                             | )          | 56,067 |   |
| Settlements on  derivatives with financing elements                                   |       | 23,311                                              |       | 17,428 |   |
| Amortization of  debt issue costs                                                     |       | 1,022                                               |       | 2,631 |   |
| Minority  interest, net of tax                                                        |       | 196                                                 |       | — |   |
|                                                                                  |       |                                                |       |   |   |
| Changes in  operating working capital:                                                |       |                                                |       |   |   |
| Accounts  receivable                                                                  |       | 116                                                 |       | (3,474 | ) |
| Accounts payable                                                                      |       | 3,073                                               |       | 3,301 |   |
| Other                                                                                 |       | (2,152                                              | )          | 967 |   |
| Net cash  provided by operating activities                                            |       | 116,482                                             |       | 126,631 |   |
|                                                                                  |       |                                                |       |   |   |
| CASH FLOWS FROM  INVESTING ACTIVITIES                                                 |       |                                                |       |   |   |
| Additions to  property and equipment                                                  |       | (188,606                                            | )          | (126,788 | ) |
| Additions to  equipment of Larclay JV                                                 |       | (46,126                                             | )          | — |   |
| Proceeds from  sales of property and equipment                                        |       | 1,083                                               |       | 23,252 |   |
| Other                                                                                 |       | 3,665                                               |       | (11,336 | ) |
| Net cash used in  investing activities                                                |       | (229,984                                            | )          | (114,872 | ) |
|                                                                                  |       |                                                |       |   |   |
| CASH FLOWS FROM  FINANCING ACTIVITIES                                                 |       |                                                |       |   |   |
| Proceeds from  long-term debt                                                         |       | 93,700                                              |       | 225,000 |   |
| Proceeds from  long-term debt of Larclay JV                                           |       | 45,761                                              |       | — |   |
| Repayments of  other long-term debt                                                   |       | (12                                                 | )          | (177,500 | ) |
| Proceeds from  sale of common stock                                                   |       | 175                                                 |       | 288 |   |
| Payment of debt  issue costs                                                          |       | —                                              |       | (7,964 | ) |
| Settlements on  derivatives with financing elements                                   |       | (23,311                                             | )          | (17,428 | ) |
| Net cash  provided by financing activities                                            |       | 116,313                                             |       | 22,396 |   |
|                                                                                  |       |                                                |       |   |   |
| NET INCREASE IN CASH  AND CASH EQUIVALENTS                                            |       | 2,811                                               |       | 34,155 |   |
|                                                                                  |       |                                                |       |   |   |
| CASH AND CASH  EQUIVALENTS                                                            |       |                                                |       |   |   |
| Beginning of  period                                                                  |       | 5,935                                               |       | 16,359 |   |
| End of period                                                                         |       | $                                                   | 8,746      |   | $ | 50,514 |   |
|                                                                                  |       |                                                |       |   |   |
| SUPPLEMENTAL  DISCLOSURES                                                             |       |                                                |       |   |   |
| Cash paid for  interest, net of amounts capitalized                                   |       | $                                                   | 17,996     |   | $ | 5,138 |   |

 

The accompanying notes are an integral part of theseconsolidated financial statements.

 

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**CLAYTON WILLIAMS ENERGY, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTSSeptember 30, 2006(Unaudited)**

**1.         Nature of Operations**

Clayton WilliamsEnergy, Inc. (a Delaware corporation) and its subsidiaries (collectively, the “Company”or “CWEI”) is an independent oil and gas company engaged in the exploration forand development and production of oil and natural gas primarily in its coreareas in Texas, Louisiana and NewMexico.  Approximately 45% of the Company’soutstanding common stock is beneficially owned by its Chairman of the Board andChief Executive Officer, Clayton W. Williams (“Mr. Williams”).  Oil and gas exploration and production is theonly significant business segment in which the Company operates.

Substantially all of the Company’s oil and gas production is sold undershort-term contracts which are market-sensitive.  Accordingly, the Company’s financialcondition, results of operations, and capital resources are highly dependentupon prevailing market prices of, and demand for, oil and natural gas.  These commodity prices are subject to widefluctuations and market uncertainties due to a variety of factors that arebeyond the control of the Company.  Thesefactors include the level of global demand for petroleum products, foreignsupply of oil and gas, the establishment of and compliance with productionquotas by oil-exporting countries, weather conditions, the price andavailability of alternative fuels, and overall economic conditions, bothforeign and domestic.

**2.         Presentation**

The preparation of these consolidated financial statements in conformitywith accounting principles generally accepted in the United States requiresmanagement of the Company to make estimates and assumptions that affect thereported amounts of assets and liabilities and disclosure of contingent assetsand liabilities at the date of the financial statements and the reportedamounts of revenues and expenses during the reporting periods.  Actual results could differ materially fromthose estimates.

The consolidated financial statements include the accounts of ClaytonWilliams Energy, Inc., its wholly-owned subsidiaries and the accounts of theLarclay JV (see Note 4).  The Companyalso accounts for its undivided interests in oil and gas limited partnershipsusing the proportionate consolidation method, whereby its share of assets,liabilities, revenues and expenses are consolidated with other operations.  All significant intercompany transactions andbalances associated with the consolidated operations have been eliminated.

In the opinion of management, the Company’s unaudited consolidatedfinancial statements as of September 30, 2006 and for the interim periods endedSeptember 30, 2006 and 2005 include all adjustments which are necessary for afair presentation in accordance with accounting principles generally acceptedin the United States.  These interimresults are not necessarily indicative of the results to be expected for theyear ending December 31, 2006.

Certain information and footnote disclosures normally included in financialstatements prepared in accordance with accounting principles generally acceptedin the United States have been condensed or omitted in this Form 10-Qpursuant to the rules and regulations of the Securities and Exchange Commission(“SEC”).  These consolidated financialstatements should be read in conjunction with the audited consolidatedfinancial statements and notes thereto included in the Company’s Form 10-K forthe year ended December 31, 2005.

8

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**3.         Recent AccountingPronouncements**

In September 2006, the Securities andExchange Commission issued Staff Accounting Bulletin No. 108 (“SAB 108”),which becomes effective beginning on January 1, 2007. SAB 108 providesguidance on the consideration of the effects of prior period misstatements inquantifying current year misstatements for the purpose of a materialityassessment. SAB 108 requires an entity to evaluate the impact of correcting allmisstatements, including both the carryover and reversing effects of prior yearmisstatements, on current year financial statements. If a misstatement ismaterial to the current year financial statements, the prior year financialstatements should also be corrected, even though such revision was, andcontinues to be, immaterial to the prior year financial statements. Correctingprior year financial statements for immaterial errors would not requirepreviously filed reports to be amended. Such correction should be made in thecurrent period filings. We are currently evaluating the impact, if any, ofadopting SAB 108.

In September 2006, the FASBissued SFAS No. 157 “Fair Value Measurements” (“SFAS 157”), whichdefines fair value, establishes a framework for measuring fair value ingenerally accepted accounting principles and expands disclosures about fairvalue measurements. This Statement applies under other accountingpronouncements that require or permit fair value measurements, the FASB havingpreviously concluded in those accounting pronouncements that fair value is therelevant measurement attribute. Accordingly, this Statement does not requireany new fair value measurements. SFAS 157 is effective for fiscal yearsbeginning after December 15, 2007. We plan to adopt SFAS 157 beginning inthe first quarter of fiscal 2008. We are currently evaluating the impact, if any,the adoption of SFAS 157 will have on our consolidated financial position,results of operations or cash flows.

Emerging Issues Task Force Issue 04-5 (“EITF 04-5”), which becameeffective January 1, 2006, requires companies to fully consolidate any limitedpartnerships that the company controls as general partner.  EITF 04-5 presumes that a sole generalpartner in a limited partnership controls the limited partnership; however, thepresumption of control can be overcome if the limited partners have (i) thesubstantive ability to remove the sole general partner or otherwise dissolvethe limited partnership or (ii) substantive participating rights.  For this purpose, the EITF has concluded thata general partner lacks control ifthe limited partners can remove the general partner with a simple majorityvote.  The Company has entered intocontracts with 17 oil and gas limited partnerships of which the Company is thesole general partner.  Generally, thesecontracts require the Company to abstain from voting any of its limitedpartnership units in matters related to the removal of the Company as generalpartner.  As a result, the limitedpartners in all of the oil and gas partnerships in which the Company serves asgeneral partner can remove the Company as general partner with a simplemajority vote.  Accordingly, the Companyhas continued consolidating its proportionate share of all of these limitedpartnerships.  The adoption of EITF 04-5had no affect on the Company’s consolidated financial statements.

In June 2006, the Financial Accounting Standards Board (“FASB”) issuedFASB Interpretation No. 48 “Accounting for Uncertainty in Income Taxes” (“FIN 48”)to clarify the manner in which enterprises account for uncertainties in theirprovisions for income taxes.  Generally,the standard presented by FIN 48 is a “more likely than not” standard andis intended to enhance the relevancy and comparability of financial reportingby companies.  FIN 48 is effectivefor fiscal years beginning after December 31, 2006.  The Company is currently reviewingFIN 48 to determine its application to the Company’s consolidatedfinancial statements.

9

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**4.         Investments**

*West Coast Energy Properties, L.P.*

In August 2006, an affiliated partnership,West Coast Energy Properties, L.P. (“WCEP”), acquired certain producing oil andgas assets in California and Texas for aggregate cash consideration ofapproximately $58 million. Approximately 75% of the purchase price relates to properties in threefields in southern California, and the remaining 25% relates primarily toproperties located in Mitchell County, Texas.

WCEP is a Texas limited partnership formedto facilitate this acquisition, the general partner of which is a limitedliability company owned by the Company and the limited partner of which is anaffiliate of GE Energy Financial Services. Under the partnership agreement, the general partner contributedapproximately $6.2 million to the partnership for an initial partnershipinterest of 5%, which interest can increase to 37.63%, and ultimately to 49%,upon the achievement of certain target rates of return.

The Company financed its equity contributionto the general partner through borrowings on its revolving credit facility.

*Larclay JV*

In April 2006, the Company formed a joint venture (“Larclay JV”) withLariat Services, Inc. (“Lariat”) to construct, own and operate 12 new drillingrigs.  The Company and Lariat each own a50% interest in Larclay JV.  The rigs arebeing constructed on behalf of Larclay JV by Lariat, as operationsmanager.  Construction of all the rigs isexpected to be completed by February 28, 2007 at a cost of approximately$75 million.  A lender has provideda $75 million secured term loan to Larclay JV to finance the construction andequipping of the rigs.  Pursuant to theterm loan, the Company has issued a $19 million letter of credit to thelender as additional collateral during the construction period.  Upon the earlier of compliance with specifiedcollateral ratios or February 28, 2007, the lender is to release the letter ofcredit in exchange for a $19.5 million guaranty from the Company.  After completion of the construction period,outstanding advances under the term loan must not exceed 75% of the appraisedvalue of the rigs.  If proceeds availableto Larclay JV under the term loan are not sufficient to fully finance the costof the rigs, the Company will be required to loan funds to Larclay JV at thesame interest rate as the term loan.  TheLarclay JV term loan bears interest at a floating rate based on a LIBOR average,plus 3.25%, and provides for monthly interest payments through March 2007 andmonthly principal and interest payments thereafter sufficient to retire theprincipal balance by 35% in the first year, 25% in each of the next two years,and 15% in the fourth year.  Twovoluntary prepayments of $10 million each may be made in 2008 and 2009 withouta prepayment penalty.  The Larclay JVterm loan prohibits Larclay JV from making any cash distributions to theCompany or Lariat until the balance on the term loan is fully repaid, andrepayments by Larclay JV of any loans by the Company or Lariat are subordinatedto the loans outstanding under the term loan and are subject to otherrestrictions.

Also in April 2006, the Company entered into a three-year drilling contractwith Larclay JV assuring the availability of each rig for use in the ordinarycourse of the Company’s exploration and development drilling program throughoutthe term of the drilling contract.  Theprovisions of the drilling contract require that the Company contract for eachrig on a well-by-well basis at then current market rates.  If a rig is not needed by the Company at anytime during the term of the contract, Larclay JV may contract with Lariat,affiliates of Lariat or other third party operators for the use of such rig,subject to certain restrictions.  If arig is idle, the Company will pay Larclay JV an idle rig rate ranging from$8,100 per day to $10,300 per day (plus crew labor expenses, if applicable),depending on the size of the rig.  TheCompany’s gross idle rig commitment under this drilling contract, excludingcrew labor, if any, aggregates $112 million.  Four rigs 

 

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are currently operational, of which two are working for the Company andtwo are working for other operators.

Although the Company and Lariat own equal interests in Larclay JV, theCompany meets the definition of the primary beneficiary of Larclay JV’sexpected cash flows under FASB Interpretation No. 46R, “Consolidation ofVariable Interest Entities — an interpretation of ARB No. 51 (as amended)”(“FIN 46R”).  As the primary beneficiaryunder FIN 46R, the Company is required to include the accounts of Larclay JV inthe Company’s consolidated financial statements.  As of September 30, 2006, Lariat’sequity ownership in the net assets of LarclayJV was $696,000, which is recorded as minority interest and included in othernon-current liabilities in the accompanying consolidated financialstatements.  The Company’s intercompanyaccounts with Larclay JV have been eliminated in consolidation.

**5.         Long-Term Debt**

Long-term debt consists of the following:

|                                             | ** ** | **September 30,**  | ** ** | **December 31,** | ** ** |
|---------------------------------------------|------------|-------------------------|------------|-----------------------|------------|
| ** **                                  | ** ** | **2006**                | ** ** | **2005**              | ** ** |
| ** **                                  | ** ** | **(In thousands)** | ** ** |
| 73¤4%  Senior Notes due 2013           |       | $                       | 225,000    |                  | $          | 225,000 |   |
| Secured bank  credit facility, due May 2009 |       | 104,400                 |       | 10,700                |       |
| Secured term  loan of Larclay JV            |       | 45,766                  |       | —                |       |
| Other                                       |       | 2                       |       | 19                    |       |
|                                        |       | 375,168                 |       | 235,719               |       |
| Less current  maturities(a)                 |       | (8,011                  | )          | (19                   | )          |
|                                        |       | $                       | 367,157    |                  | $          | 235,700 |   |

----

(a)             Includescurrent portion of term loan of Larclay JV of $8,009 at September 30,2006.

*7*3¤4*% Senior Notes due 2013*

In July 2005, the Company issued, in a privateplacement, $225 million of aggregate principal amount of 73¤4% Senior Notes due 2013 (“Senior Notes”).  The Senior Notes were issued at face valueand bear interest at 73¤4% per year, payable semi-annually onFebruary 1 and August 1 of each year, beginning February 1, 2006.  After the payment of typical transactionexpenses, net proceeds of approximately $217 million were used to repayall amounts outstanding under the secured bank credit facilities and forgeneral corporate purposes, including the funding of planned exploration anddevelopment activities.

At any time prior to August 1, 2008, the Company mayredeem up to 35% of the aggregate principal amount of the Senior Notes with theproceeds of certain equity offerings at a redemption price of 107.75% of theprincipal amount, plus accrued and unpaid interest.  In addition, prior to August 1, 2009, theCompany may redeem some or all of the Senior Notes at a redemption price equalto 100% of the principal amount of the Senior Notes to be redeemed, plus amake-whole premium, plus any accrued and unpaid interest.  On and after August 1, 2009, the Company mayredeem some or all of the Senior Notes at redemption prices (expressed aspercentages of principal amount) equal to 103.875% for the twelve-month periodbeginning on August 1, 2009, 101.938% for the twelve-month periodbeginning on August 1, 2010, and 100.00% beginning on August 1, 2011, for anyperiod thereafter, in each case plus accrued and unpaid interest.

The Indenture governing the Senior Notes restricts theability of the Company and its restricted subsidiaries to:  (i) borrow money; (ii) issueredeemable and preferred stock; (iii) pay distributions or 

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dividends; (iv) make investments; (v) createliens without securing the Senior Notes; (vi) enter into agreements thatrestrict dividends from subsidiaries; (vii) sell certain assets or mergewith or into other companies; (viii) enter into transactions withaffiliates; (ix) guarantee indebtedness; and (x) enter into new linesof business.  The Company was incompliance with these covenants at September 30, 2006.

*Secured Bank Credit Facility*

The Company’s secured bank credit facility providesfor a revolving loan facility in an amount not to exceed the lesser of theborrowing base, as established by the banks, or that portion of the borrowingbase determined by the Company to be the elected borrowing limit.  Theborrowing base, which is based on the discounted present value of future netrevenues from oil and gas production, is subject to redetermination at anytime, but at least semi-annually in May and November, and is made at thediscretion of the banks.  If, at any time, the redetermined borrowing baseis less than the amount of outstanding indebtedness, the Company will berequired to (i) pledge additional collateral, (ii) prepay the excess in notmore than five equal monthly installments, or (iii) elect to convert the entireamount of outstanding indebtedness to a term obligation based on amortizationformulas set forth in the loan agreement.  Substantially all of theCompany’s oil and gas properties are pledged to secure advances under thecredit facility.  At September 30, 2006,the borrowing base established by the banks was $200 million, with nomonthly commitment reductions.  After allowing for outstanding letters ofcredit totaling $19.8 million, the Company had $75.8 millionavailable under the credit facility at September 30, 2006.

The revolving credit facility provides for interest atrates based on the agent bank’s prime rate plus margins ranging from .25% to1%, or if elected by the Company based on LIBOR plus margins ranging from 1.5%to 2.25%.  The Company also pays acommitment fee on the unused portion of the revolving credit facility.  Interest and fees are payable at leastquarterly.  The effective annual interestrate on borrowings under the combined credit facility, excluding bank fees andamortization of debt issue costs, for the nine months ended September 30, 2006was 7.4%.

The loan agreement applicable to the revolving creditfacility contains financial covenants that are computed quarterly.  The working capital covenant requires theCompany to maintain a ratio of current assets to current liabilities of atleast 1 to 1.  Another financial covenantunder the credit facility requires the Company to maintain a ratio ofindebtedness to cash flow of no more than 3 to 1.  The computations of current assets, currentliabilities, cash flow and indebtedness are defined in the loan agreement.  The Company was in compliance with allfinancial and non-financial covenants at September 30, 2006.

*Secured Term Loan of Larclay JV*

In connection with the Company’s investment in LarclayJV (see Note 4), Larclay JV obtained a $75 million secured term loanfacility from a lender to finance the construction and equipping of 12 newdrilling rigs.  The Larclay JV term loanis secured by substantially all of the assets of Larclay JV and a$19 million letter of credit from the Company, which letter of credit isto be replaced prior to February 28, 2007 by a $19.5 million guaranty fromthe Company.  Although the Company is nota maker on the Larclay JV term loan, it has provided the letter of creditand guaranty as credit support for the Larclay JV term loan and isrequired to fully consolidate the accounts of Larclay JV under FIN 46R.  At September 30, 2006, the effectiveinterest rate on the Larclay JV term loan was 8.5%.  Larclay JV capitalized $1.1 million ofinterest expense related to the construction phase of the drilling rigs.

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**6.         OtherNon-Current Liabilities**

Other non-current liabilities consist of thefollowing:

|                                | ** ** | **September 30,**  | ** ** | **December 31,** | ** ** |
|--------------------------------|------------|-------------------------|------------|-----------------------|------------|
| ** **                     | ** ** | **2006**                | ** ** | **2005**              | ** ** |
| ** **                     | ** ** | **(In thousands)** | ** ** |
| Abandonment  obligations       |       | $                       | 21,293     |                  | $          | 19,447 |   |
| Minority  interest, net of tax |       | 696                     |       | —                |       |
| Other                          |       | 879                     |       | 896                   |       |
|                           |       | $                       | 22,868     |                  | $          | 20,343 |   |

 

Changes in abandonmentobligations for the nine months ended September 30, 2006 and 2005 are asfollows:

|                                                   | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------------------------|------------|---------------------------------|------------|
| ** **                                        | ** ** | **September 30,**          | ** ** |
| ** **                                        | ** ** | **2006**                        | ** ** | **2005** | ** ** |
| ** **                                        | ** ** | **(In thousands)**         | ** ** |
| Beginning of  period                              |       | $                               | 19,447     |   | $ | 16,147 |   |
| Additional abandonment obligations from new wells |       | 834                             |       | 492 |   |
| Sales or abandonments of properties               |       | (195                            | )          | (507 | ) |
| Revisions of previous estimates                   |       | (17                             | )          | 27 |   |
| Accretion expense                                 |       | 1,224                           |       | 858 |   |
| End of period                                     |       | $                               | 21,293     |   | $ | 17,017 |   |

 

**7.****                          Compensation Plans**

*Stock-Based Compensation*

In January 2006, the Company adoptedStatement of Financial Accounting Standards No. 123 (revised 2004) “Share-BasedPayments” (“SFAS 123R”). SFAS 123R requires that the cost from all share-based paymenttransactions, including stock options, be recognized in the financialstatements at fair value.  Under SFAS 123R,compensation expense related to the grant of stock options will be determinedbased on the grant date fair value of future awards.  Prior to adoption of SFAS 123R, theCompany accounted for stock-based compensation utilizing the intrinsic valuemethod prescribed by Accounting Principles Board Opinion No. 25 “Accountingfor Stock Issued to Employee” (“APB 25”) and related interpretations.

The Company has accounted for options whichwere repriced in 1999 as variable stock options under APB 25 wherebycompensation expense has been recognized through December 31, 2005 forunexercised options based on changes in the market value of the Company’scommon stock.  In accordance withSFAS 123R, the Company ceased accounting for these options as variablestock options upon the adoption date. The Company adopted SFAS 123R using the modified prospectiveapplication method.  Since all of theCompany’s outstanding options were fully vested at January 1, 2006, nofuture compensation expense will be recognized under SFAS 123R unless theoptions are modified, and the Company did not recognize any cumulative effectof a change in accounting principles upon adoption of SFAS 123R.

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Compensation expense related to stock-basedcompensation plans for the nine months ended September 30, 2005 was$2.1 million.

The Company has reserved 1,798,200 sharesof common stock for issuance under the 1993 Stock Compensation Plan (“1993 Plan”).  The Plan provides for the issuance ofnonqualified stock options with an exercise price which is not less than themarket value of the Company’s common stock on the date of grant.  All options granted through September 30,2006 expire 10 years from the date of grant and become exercisable based onvarying vesting schedules.

The Company has reserved 86,300 shares ofcommon stock for issuance under the Outside Directors Stock Option Plan (“DirectorsPlan”).  Since the inception of theDirectors Plan, the Company has issued options covering 44,000 shares of commonstock at option prices ranging from $3.25 to $41.74 per share.  All outstanding options expire 10 years fromthe grant date and are fully exercisable upon issuance.

The following table sets forth certaininformation regarding the Company’s stock option plans as of and for the ninemonths ended September 30, 2006:
| ** **                         | ** ** | ** ** | ** ** | ** **   | ** ** | **Weighted**    | ** ** | ** **    | ** ** |
|------------------------------------|------------|------------|------------|--------------|------------|-----------------|------------|---------------|------------|
| ** **                         | ** ** | ** ** | ** ** | **Weighted** | ** ** | **Average**     | ** ** | ** **    | ** ** |
| ** **                         | ** ** | ** ** | ** ** | **Average**  | ** ** | **Remaining**   | ** ** | **Aggregate** | ** ** |
| ** **                         | ** ** | ** ** | ** ** | **Exercise** | ** ** | **Contractual** | ** ** | **Intrinsic** | ** ** |
| ** **                         | ** ** | **Shares** | ** ** | **Price**    | ** ** | **Term**        | ** ** | **Value**     | ** ** |
| Outstanding at  January 1, 2006    |       | 1,338,551  |       | $            | 19.53      |            |       |          |       |   |
| Granted                            |       | 4,000      |       | $            | 41.74      |            |       |          | $          | — |   |
| Exercised                          |       | (30,566    | )          | $            | 5.72       |            |       |          | $          | 1,374,305 |   |
| Outstanding at  September 30, 2006 |       | 1,311,985  |       | $            | 19.98      |            | 5.3        |          | $          | 13,533,159 |   |
| Vested at  September 30, 2006      |       | 1,311,985  |       | $            | 19.98      |            | 5.3        |          | $          | 13,533,159 |   |
| Exercisable at  September 30, 2006 |       | 1,311,985  |       | $            | 19.98      |            | 5.3        |          | $          | 13,533,159 |   |

 

The following pro forma information, asrequired by Statement of Financial Accounting Standards No. 123 “Accountingfor Stock-Based Compensation” (“SFAS 123”), as amended by Statementof Financial Accounting Standards No. 148 (“SFAS 148”), presents netincome and earnings per share information as if the stock options issued sinceDecember 31, 1994 were accounted for using the fair value method underSFAS 123.  The fair value of stockoptions issued for each year was estimated at the date of grant using the Black-Scholesoption pricing model.

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The SFAS 123 pro forma information forthe nine months ended September 30, 2005 is as follows:
| ** **                                                                                                          | ** ** | **Nine Months**                                 | ** ** |
|---------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                                                          | ** ** | **Ended**                                            | ** ** |
| ** **                                                                                                          | ** ** | **September 30,  2005**                         | ** ** |
| ** **                                                                                                          | ** ** | **(In thousands,  except per share)** | ** ** |
| Net loss, as  reported                                                                                              |       | $                                                    | (1,082     | ) |
| Add: Stock-based employee compensation expense  included in net loss, net of tax                                    |       | 1,384                                                |       |
| Deduct: Stock-based employee compensation expense  determined under fair value based method (SFAS 123R), net of tax |       | (2,920                                               | )          |
| Net loss, pro  forma                                                                                                |       | $                                                    | (2,618     | ) |
|                                                                                                                |       |                                                 |       |
| Basic:                                                                                                              |       |                                                 |       |
| Net loss per common share, as reported                                                                              |       | $                                                    | (.10       | ) |
| Net loss per common share, pro forma                                                                                |       | $                                                    | (.24       | ) |
|                                                                                                                |       |                                                 |       |
| Diluted:                                                                                                            |       |                                                 |       |
| Net loss per common share, as reported                                                                              |       | $                                                    | (.10       | ) |
| Net loss per  common share, pro forma                                                                               |       | $                                                    | (.24       | ) |

 

*After-PayoutIncentive Plan*

The CompensationCommittee of the Board of Directors has adopted an incentive plan for officers,key employees and consultants, excluding Mr. Williams, who promote theCompany’s drilling and acquisition programs. Management’s objective in adopting this plan is to further align theinterests of the participants with those of the Company by granting theparticipants an after-payout interest in the production developed, directly orindirectly, by the participants.  Theplan generally provides for the creation of a series of partnerships between theCompany and the participants to which the Company contributes a portion of itseconomic interest in wells drilled or acquired within certain areas.  Generally, the Company pays all costs andreceives all revenues until payout of its costs, plus interest.  At payout, the participants receive 99% to100% of all subsequent revenues and pay 99% to 100% of all subsequent expensesattributable to the partnerships’ interests.

Between 3% and7.5% of the Company’s economic interests in specified wells drilled or acquiredby the Company subsequent to October 2002 are subject to this arrangement(excluding properties acquired in a merger with Southwest Royalties, Inc. inMay 2004).  The Company records itsallocable share of the assets, liabilities, revenues, expenses and oil and gasreserves of these partnerships in its consolidated financial statements.  To date, two of these partnerships haveachieved payout.  Aggregate cashdistributions of approximately $598,000 were paid to the participants duringthe nine months ended September 30, 2006. The Company recognized $1.5 million of non-cash compensationexpense during the nine months ended September 30, 2006 for the estimated valueof the after-payout interests subject to this arrangement.

**8.         Derivatives**

# *Commodity Derivatives*

From time to time, the Company utilizes commodityderivatives, consisting of swaps, floors and collars, to attempt to optimizethe price received for its oil and gas production.  When using swaps to hedge oil and natural gasproduction, the Company receives a fixed price for the respective commodity 

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andpays a floating market price as defined in each contract (generally NYMEXfutures prices), resulting in a net amount due to or from thecounterparty.  In floor transactions, theCompany receives a fixed price (put strike price) if the market price fallsbelow the put strike price for the respective commodity.  If the market price is greater than the putstrike price, no payments are due from either party.  Costless collars are a combination of putsand calls, and contain a fixed floor price (put strike price) and ceiling price(call strike price).  If the market pricefor the respective commodity exceeds the call strike price or falls below theput strike price, then the Company receives the fixed price and pays the marketprice.  If the market price is betweenthe call and the put strike prices, no payments are due from either party.  Commodity derivatives are settled monthly asthe contract production periods mature.

The following summarizes information concerning theCompany’s net positions in open commodity derivatives applicable to periodssubsequent to September 30, 2006.  Thesettlement prices of commodity derivatives are based on NYMEX futures prices.

**Collars:**
| ** **            | ** ** | **Gas**            | ** ** | **Oil**   | ** ** |
|-----------------------|------------|--------------------|------------|-----------|------------|
| ** **            | ** ** | **MMBtu (a)** | ** ** | **Floor** | ** ** | **Ceiling** | ** ** | **Bbls** | ** ** | **Floor** | ** ** | **Ceiling** | ** ** |
| Production  Period:   |       |               |       |      |       |   |   |   |   |   |   |   |   |
| 4th Quarter 2006 |       | 456,000            |       | $         | 4.00       |   | $ | 5.21 |   | 150,000 |   | $ | 23.00 |   | $ | 25.32 |   |
| 2007                  |       | 1,831,000          |       | $         | 4.00       |   | $ | 5.18 |   | 562,000 |   | $ | 23.00 |   | $ | 25.20 |   |
| 2008                  |       | 1,279,000          |       | $         | 4.00       |   | $ | 5.15 |   | 392,000 |   | $ | 23.00 |   | $ | 25.07 |   |
|                  |       | 3,566,000          |       |      |       |   |   | 1,104,000 |   |   |   |   |   |

 

**Swaps:**
| ** **            | ** ** | **Gas**            | ** ** | **Oil**   | ** ** |
|-----------------------|------------|--------------------|------------|-----------|------------|
| ** **            | ** ** | **MMBtu (a)** | ** ** | **Price** | ** ** | **Bbls** | ** ** | **Price** | ** ** |
| Production  Period:   |       |               |       |      |       |   |   |   |   |
| 4th Quarter 2006 |       | 1,050,000          |       | $         | 10.03      |   | 75,000 |   | $ | 71.60 |   |
| 2007                  |       | 5,100,000          |       | $         | 9.20       |   | 900,000 |   | $ | 70.06 |   |
| 2008                  |       | 3,600,000          |       | $         | 8.37       |   | 360,000 |   | $ | 69.55 |   |
|                  |       | 9,750,000          |       |      |       | 1,335,000 |   |   |   |

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(a)             OneMMBtu equals one Mcf at a Btu factor of 1,000.

In August 2006, the Company terminatedcertain fixed-price gas swaps covering 9,010,000 MMBtu of gas production at anaverage price of $9.26 per Mcf for the period from November 2006 throughDecember 2007.  The Company received cashproceeds of $6.1 million upon termination of these contracts.

In July 2006, the Company also terminatedcertain fixed-price oil swaps covering 300,000 barrels at a price of$80.45 per barrel, from January 2007 through December 2007, resulting in anaggregate loss of approximately $2.4 million, which will be paid to thecounterparty monthly during 2007.

# *Interest Rate Derivatives*

The Company is a party to interest rate swapsthat were acquired in connection with the acquisition of Southwest Royalties,Inc. in May 2004.  Under thesederivatives, the Company pays a fixed rate for the notional principal balancesand receives a floating market rate based on LIBOR.  The interest rate swaps are settledquarterly.  The following summarizesinformation concerning the Company’s net positions in open interest rate swapsapplicable to periods subsequent to September 30, 2006.

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**InterestRate Swaps:**

|                                       | ** ** | **Principal** | ** ** | **Fixed  Libor** | ** ** |
|---------------------------------------|------------|---------------|------------|------------------|------------|
| ** **                            | ** ** | **Balance**   | ** ** | **Rates**        | ** ** |
| Period:                               |       |          |       |             |       |
| October 1, 2006  to November 1, 2006  |       | $             | 55,000,000 |             | 4.29       | % |
| November 1, 2006  to November 1, 2007 |       | $             | 50,000,000 |             | 5.19       | % |
| November 1, 2007 to  November 1, 2008 |       | $             | 45,000,000 |             | 5.73       | % |

 

*Accounting For Derivatives*

The Company accounts forits derivatives in accordance with Statement of Financial Accounting StandardsNo. 133 “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”),as amended.  The Company did notdesignate any of its currently open commodity or interest rate derivatives ascash flow hedges; therefore, all changes in the fair value of these contractsprior to maturity, plus any realized gains or losses at maturity, are recordedas other income (expense) in the Company’s statements of operations.  For the nine months ended September 30,2006, the Company reported a $25.4 million gain on derivatives, consistingof a $42.7 million gain related to changes in mark-to-market valuationsand a $17.3 million cash charge for settled contracts.  For the nine months ended September 30,2005, loss on derivates was $28.8 million, consisting of a$20.8 million non-cash charge related to changes in mark-to-marketvaluations and an $8 million cash charge for settled contracts.

**9.         Financial Instruments**

Cash and cash equivalents,receivables, accounts payable and accrued liabilities were each estimated tohave a fair value approximating the carrying amount due to the short maturityof those instruments.  Indebtedness underthe secured bank credit facilities was estimated to have a fair valueapproximating the carrying amount since the stated interest rate is generallymarket sensitive.  The fair value ofother noncurrent liabilities approximate their carrying value.

The fair values ofderivatives as of September 30, 2006 and December 31, 2005 are set forthbelow.  The associated carrying values atthese dates are equal to their estimated fair values.

|                            | ** ** | **September 30,**  | ** ** | **December 31,** | ** ** |
|----------------------------|------------|-------------------------|------------|-----------------------|------------|
| ** **                 | ** ** | **2006**                | ** ** | **2005**              | ** ** |
| ** **                 | ** ** | **(In thousands)** | ** ** |
| Assets (liabilities):      |       |                    |       |                  |       |
| Commodity  derivatives     |       | $                       | (40,028    | )                     | $          | (82,635 | ) |
| Interest rate  derivatives |       | (345                    | )          | (422                  | )          |
| Net assets  (liabilities)  |       | $                       | (40,373    | )                     | $          | (83,057 | ) |

 

**10.      Income Taxes**

In May 2006, the State of Texas adopted House Bill 3, which modified thestate’s franchise tax structure, replacing the previous tax based on capital orearned surplus with a margin tax (the “Texas Margin Tax”) effective withfranchise tax reports filed on or after January 1, 2008.  The Texas Margin Tax is computed by applyingthe applicable tax rate (1% for the Company’s business sector) to the profitmargin, which is generally determined by total revenue less either cost ofgoods sold or compensation, as applicable. 

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Although House Bill 3 states that the Texas Margin Tax is not an incometax, the Company believes that Statement of Financial Accounting StandardsNo. 109 “Accounting for Income Taxes” (“SFAS 109”) applies to theTexas Margin Tax.  Accordingly, theCompany has computed its consolidated deferred tax liability based on itscurrent interpretation of the Texas Margin Tax, resulting in a reduction ofdeferred tax expense during the quarter ended June 30, 2006 of$4.1 million.

The Company’s effective federal and state income tax rate for the ninemonths ended September 30, 2006 of 22.4% differed from the statutoryfederal rate of 35% due to reductions in the tax provision related to theadoption of the Texas Margin Tax and statutory depletion, offset in part bycertain non-deductible expenses.

**11.      Commitments**

The Company is presently obligated under firmorders for two drilling rigs and related equipment in an aggregate amount of$24.5 million, of which cash deposits totaling $8.1 million have beenpaid to certain equipment suppliers as of September 30, 2006.  The total cost of the rigs, when completedand fully equipped, will be approximately $27 million.  The rigs are scheduled for delivery inmid-2007 and are expected to be utilized to drill the Company’s deep Bossierprospects in East Texas and North Louisiana.

In addition to the Larclay JV drilling contractdiscussed in Note 4, the Company has also entered into three long-termdrilling contracts with third party drilling contractors and is obligated tomake payments under these contracts totaling $11 million in the fourthquarter of 2006 and $25 million in 2007.

**12.      Oil and Gas Properties**

The following sets forth the capitalized costs foroil and gas properties as of September 30, 2006 and December 31,2005.

|                                                       | ** ** | **September 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|-------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                                            | ** ** | **(In thousands)**      | ** ** |
| Proved properties                                     |       | $                            | 1,037,610  |                        | $          | 957,962 |   |
| Unproved properties                                   |       | 150,806                      |       | 79,900                      |       |
| Total capitalized costs                               |       | 1,188,416                    |       | 1,037,862                   |       |
| Accumulated  depreciation, depletion and amortization |       | (629,083                     | )          | (570,386                    | )          |
| Net capitalized costs                                 |       | $                            | 559,333    |                        | $          | 467,476 |   |

 

In April 2005, the Financial Accounting Standards Board issued StaffPosition No. 19-1 (“FSP 19-1”).  FSP 19-1 amends the present guidance inStatement of Financial Accounting Standards No. 19, paragraphs 31 and 34,regarding when exploratory drilling costs pending determination of provedreserves can be carried as an asset of an oil and gas company that uses thesuccessful efforts method of accounting. The Company was required to adopt FSP 19-1, including itsdisclosures, effective July 1, 2005.  Theadoption of FSP 19-1 did not have a significant impact on the Company’sresults of operations.  At September 30,2006 and December 31, 2005, the Company had capitalized $31.9 millionand $10.3 million, respectively, of exploratory drilling costs applicableto wells that were pending determination of proved reserves.  Of the $10.3 million costs atDecember 31, 2005, $1.2 million was expensed as a dry hole during thenine months ended September 30, 2006 and the remaining $9.1 million wassubsequently deemed productive.

18

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During the quarter ended September 30, 2006, theCompany recorded a provision for impairment of proved properties of $12.9million under Statement of Financial Accounting Standards No. 144 “Accountingfor Impairment or Disposal of Long-Lived Assets” (“SFAS 144”) due to thecombination of production performance and lower commodity prices.  The provision was attributable to two areasin West Texas and one area in South Louisiana.

**13.      Guarantor FinancialInformation**

In July 2005, Clayton Williams Energy, Inc. (“Issuer”) issued$225 million of Senior Notes (see Note 5).  Other than West Coast Energy Properties GP,LLC (“WCEP LLC”), the general partner of WCEP (see Note 4), all of the Issuer’swholly-owned and active subsidiaries (“Guarantor Subsidiaries”) have jointlyand severally, irrevocably and unconditionally guaranteed the performance andpayment when due of all obligations under the Senior Notes.  Larclay JV, a 50%-owned drilling rigjoint venture formed in April 2006, and WCEP, LLC have not guaranteed theSenior Notes and are referred to in this Note 13 as Non-Guarantor Entities.

The following financial information sets forth the Company’s condensedconsolidating financial statements as of and for the periods indicated.

**CondensedConsolidating Balance SheetSeptember 30, 2006**
| **(Unaudited)**                                  | ** ** | ** ** | ** ** | ** **       | ** ** | **Non-**      | ** ** | ** **       | ** ** | ** **       | ** ** |
|--------------------------------------------------|------------|------------|------------|------------------|------------|---------------|------------|------------------|------------|------------------|------------|
| **(Dollars in thousands)**             | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Guarantor** | ** ** | **Adjustments/** | ** ** | ** **       | ** ** |
| ** **                                       | ** ** | **Issuer** | ** ** | **Subsidiaries** | ** ** | **Entities**  | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                       | ** ** | ** ** | ** ** | ** **       | ** ** | ** **    | ** ** | ** **       | ** ** | ** **       | ** ** |
| Current assets                                   |       | $          | 146,450    |             | $          | 96,432        |       | $                | 5,276      |             | $          | (144,097 | ) | $ | 104,061 |   |
|                                             |       |       |       |             |       |          |       |             |       |             |       |
| Property and equipment,  net                     |       | 287,297    |       | 273,369          |       | 53,745        |       | (448             | )          | 613,963          |       |
|                                             |       |       |       |             |       |          |       |             |       |             |       |
| Investments in  subsidiaries                     |       | 65,393     |       | —           |       | —        |       | (65,393          | )          | —           |       |
|                                             |       |       |       |             |       |          |       |             |       |             |       |
| Other assets                                     |       | 23,803     |       | 371              |       | 720           |       | —           |       | 24,894           |       |
|                                             |       |       |       |             |       |          |       |             |       |             |       |
| Total assets                                     |       | $          | 522,943    |             | $          | 370,172       |       | $                | 59,741     |             | $          | (209,938 | ) | $ | 742,918 |   |
|                                             |       |       |       |             |       |          |       |             |       |             |       |
|                                             |       |       |       |             |       |          |       |             |       |             |       |
| Current liabilities                              |       | $          | 86,594     |             | $          | 168,320       |       | $                | 20,256     |             | $          | (144,097 | ) | $ | 131,073 |   |
|                                             |       |       |       |             |       |          |       |             |       |             |       |
| Non-current liabilities:                         |       |       |       |             |       |          |       |             |       |             |       |
| Long-term debt                                   |       | 329,400    |       | —           |       | 37,757        |       | —           |       | 367,157          |       |
| Fair value of  derivatives                       |       | 1,212      |       | 28,518           |       | —        |       | —           |       | 29,730           |       |
| Other                                            |       | 16,851     |       | 50,003           |       | 100           |       | 696              |       | 67,650           |       |
|                                             |       | 347,463    |       | 78,521           |       | 37,857        |       | 696              |       | 464,537          |       |
|                                             |       |       |       |             |       |          |       |             |       |             |       |
| Stockholders’ equity                        |       | 88,886     |       | 123,331          |       | 1,628         |       | (66,537          | )          | 147,308          |       |
| Total liabilities and stockholders’  equity |       | $          | 522,943    |             | $          | 370,172       |       | $                | 59,741     |             | $          | (209,938 | ) | $ | 742,918 |   |

 

19

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**Condensed Consolidating Balance SheetDecember 31, 2005****(Unaudited(Dollars in thousands)**
| ** **                                       | ** ** | **Issuer** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-Guarantor  Entities** | ** ** | **Adjustments/  Eliminations** | ** ** | **Consolidated** | ** ** |
|--------------------------------------------------|------------|------------|------------|-----------------------------|------------|-----------------------------|------------|--------------------------------|------------|------------------|------------|
| ** **                                       | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                  | ** ** | ** **                     | ** ** | ** **       | ** ** |
| Current assets                                   |       | $          | 188,007    |                        | $          | 96,327                      |       | $                              | —     |             | $          | (195,892 | ) | $ | 88,442 |   |
|                                             |       |       |       |                        |       |                        |       |                           |       |             |       |
| Property and equipment,  net                     |       | 195,987    |       | 278,080                     |       | —                      |       | —                         |       | 474,067          |       |
|                                             |       |       |       |                        |       |                        |       |                           |       |             |       |
| Investments in  subsidiaries                     |       | 65,005     |       | —                      |       | —                      |       | (65,005                        | )          | —           |       |
|                                             |       |       |       |                        |       |                        |       |                           |       |             |       |
| Other assets                                     |       | 24,491     |       | 335                         |       | —                      |       | —                         |       | 24,826           |       |
| Total assets                                     |       | $          | 473,490    |                        | $          | 374,742                     |       | $                              | —     |             | $          | (260,897 | ) | $ | 587,335 |   |
|                                             |       |       |       |                        |       |                        |       |                           |       |             |       |
| Current liabilities                              |       | $          | 126,299    |                        | $          | 193,864                     |       | $                              | —     |             | $          | (195,909 | ) | $ | 124,254 |   |
|                                             |       |       |       |                        |       |                        |       |                           |       |             |       |
| Non-current  liabilities:                        |       |       |       |                        |       |                        |       |                           |       |             |       |
| Long-term debt                                   |       | 235,700    |       | —                      |       | —                      |       | —                         |       | 235,700          |       |
| Fair value of  derivatives                       |       | 610        |       | 49,095                      |       | —                      |       | —                         |       | 49,705           |       |
| Other                                            |       | 8,280      |       | 49,105                      |       | —                      |       | —                         |       | 57,385           |       |
|                                             |       | 244,590    |       | 98,200                      |       | —                      |       | —                         |       | 342,790          |       |
|                                             |       |       |       |                        |       |                        |       |                           |       |             |       |
| Stockholders’ equity                        |       | 102,601    |       | 82,678                      |       | —                      |       | (64,988                        | )          | 120,291          |       |
| Total  liabilities and stockholders’ equity |       | $          | 473,490    |                        | $          | 374,742                     |       | $                              | —     |             | $          | (260,897 | ) | $ | 587,335 |   |

** **

**Condensed Consolidating Statement of OperationsThree Months Ended September 30, 2006****(Unaudited)(Dollars in thousands)**
| ** **                     | ** ** | **Issuer** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-Guarantor  Entities** | ** ** | **Adjustments/  Eliminations** | ** ** | **Consolidated** | ** ** |
|--------------------------------|------------|------------|------------|-----------------------------|------------|-----------------------------|------------|--------------------------------|------------|------------------|------------|
| ** **                     | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                  | ** ** | ** **                     | ** ** | ** **       | ** ** |
| Total revenue                  |       | $          | 37,055     |                        | $          | 27,844                      |       | $                              | 3,491      |             | $          | (2,001 | ) | $ | 66,389 |   |
| Costs and  expenses            |       | 59,448     |       | 17,246                      |       | 2,810                       |       | (1,639                         | )          | 77,865           |       |
| Operating income  (loss)       |       | (22,393    | )          | 10,598                      |       | 681                         |       | (362                           | )          | (11,476          | )          |
|                           |       |       |       |                        |       |                        |       |                           |       |             |       |
| Other income  (expense)        |       | 7,192      |       | 12,804                      |       | (173                        | )          | —                         |       | 19,823           |       |
|                           |       |       |       |                        |       |                        |       |                           |       |             |       |
| Income tax  expense            |       | (2,842     | )          | —                      |       | —                      |       | —                         |       | (2,842           | )          |
|                           |       |       |       |                        |       |                        |       |                           |       |             |       |
| Minority  interest, net of tax |       | (156       | )          | —                      |       | —                      |       | —                         |       | (156             | )          |
|                           |       |       |       |                        |       |                        |       |                           |       |             |       |
| Net income (loss)              |       | $          | (18,199    | )                           | $          | 23,402                      |       | $                              | 508        |             | $          | (362 | ) | $ | 5,349 |   |

** **

** **

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**Condensed Consolidating Statement of OperationsNine Months Ended September 30, 2006****(Unaudited)(Dollars in thousands)**
| ** **                     | ** ** | **Issuer** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-Guarantor  Entities** | ** ** | **Adjustments/  Eliminations** | ** ** | **Consolidated** | ** ** |
|--------------------------------|------------|------------|------------|-----------------------------|------------|-----------------------------|------------|--------------------------------|------------|------------------|------------|
| ** **                     | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                  | ** ** | ** **                     | ** ** | ** **       | ** ** |
| Total revenue                  |       | $          | 116,337    |                        | $          | 83,000                      |       | $                              | 4,238      |             | $          | (3,451 | ) | $ | 200,124 |   |
| Costs and  expenses            |       | 123,973    |       | 51,380                      |       | 3,397                       |       | (3,003                         | )          | 175,747          |       |
| Operating income  (loss)       |       | (7,636     | )          | 31,620                      |       | 841                         |       | (448                           | )          | 24,377           |       |
|                           |       |       |       |                        |       |                        |       |                           |       |             |       |
| Other income  (expense)        |       | 3,432      |       | 7,044                       |       | (212                        | )          | —                         |       | 10,264           |       |
|                           |       |       |       |                        |       |                        |       |                           |       |             |       |
| Income tax  expense            |       | (7,754     | )          | —                      |       | —                      |       | —                         |       | (7,754           | )          |
|                           |       |       |       |                        |       |                        |       |                           |       |             |       |
| Minority  interest, net of tax |       | (196       | )          | —                      |       | —                      |       | —                         |       | (196             | )          |
|                           |       |       |       |                        |       |                        |       |                           |       |             |       |
| Net income (loss)              |       | $          | (12,154    | )                           | $          | 38,664                      |       | $                              | 629        |             | $          | (448 | ) | $ | 26,691 |   |

** **

**Condensed Consolidating Statement of OperationsThree Months Ended September 30, 2005****(Unaudited)(Dollars in thousands)**
| ** **               | ** ** | **Issuer** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-Guarantor  Entities** | ** ** | **Adjustments/  Eliminations** | ** ** | **Consolidated** | ** ** |
|--------------------------|------------|------------|------------|-----------------------------|------------|-----------------------------|------------|--------------------------------|------------|------------------|------------|
| ** **               | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                  | ** ** | ** **                     | ** ** | ** **       | ** ** |
| Total revenue            |       | $          | 55,165     |                        | $          | 30,204                      |       | $                              | —     |             | $          | (226 | ) | $ | 85,143 |   |
| Costs and  expenses      |       | 39,178     |       | 16,907                      |       | —                      |       | (226                           | )          | 55,859           |       |
| Operating income  (loss) |       | 15,987     |       | 13,297                      |       | —                      |       | —                         |       | 29,284           |       |
|                     |       |       |       |                        |       |                        |       |                           |       |             |       |
| Other income  (expense)  |       | (4,972     | )          | (27,980                     | )          | —                      |       | —                         |       | (32,952          | )          |
|                     |       |       |       |                        |       |                        |       |                           |       |             |       |
| Income tax  expense      |       | 1,628      |       | —                      |       | —                      |       | —                         |       | 1,628            |       |
|                     |       |       |       |                        |       |                        |       |                           |       |             |       |
| Net income (loss)        |       | $          | 12,643     |                        | $          | (14,683                     | )          | $                              | —     |             | $          | — |   | $ | (2,040 | ) |

** **

**Condensed Consolidating Statement of OperationsNine Months Ended September 30, 2005****(Unaudited)(Dollars in thousands)**
| ** **               | ** ** | **Issuer** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-Guarantor  Entities** | ** ** | **Adjustments/  Eliminations** | ** ** | **Consolidated** | ** ** |
|--------------------------|------------|------------|------------|-----------------------------|------------|-----------------------------|------------|--------------------------------|------------|------------------|------------|
|                     |       |       |       |                        |       |                        |       |                           |       |             |       |
| Total revenue            |       | $          | 140,709    |                        | $          | 77,669                      |       | $                              | —     |             | $          | (1,228 | ) | $ | 217,150 |   |
| Costs and  expenses      |       | 95,837     |       | 43,452                      |       | —                      |       | (1,228                         | )          | 138,061          |       |
| Operating income  (loss) |       | 44,872     |       | 34,217                      |       | —                      |       | —                         |       | 79,089           |       |
|                     |       |       |       |                        |       |                        |       |                           |       |             |       |
| Other income  (expense)  |       | (12,411    | )          | (69,303                     | )          | —                      |       | —                         |       | (81,714          | )          |
|                     |       |       |       |                        |       |                        |       |                           |       |             |       |
| Income tax  expense      |       | 1,543      |       | —                      |       | —                      |       | —                         |       | 1,543            |       |
|                     |       |       |       |                        |       |                        |       |                           |       |             |       |
| Net income (loss)        |       | $          | 34,004     |                        | $          | (35,086                     | )          | $                              | —     |             | $          | — |   | $ | (1,082 | ) |

 

 

 

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**Condensed Consolidating Statement of Cash FlowsNine Months Ended September 30, 2006****(Unaudited)Dollars in thousands)**
| ** **                                            | ** ** | **Issuer** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-Guarantor  Entities** | ** ** | **Adjustments/  Eliminations** | ** ** | **Consolidated** | ** ** |
|-------------------------------------------------------|------------|------------|------------|-----------------------------|------------|-----------------------------|------------|--------------------------------|------------|------------------|------------|
| ** **                                            | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                  | ** ** | ** **                     | ** ** | ** **       | ** ** |
| Operating  activities                                 |       | $          | 49,841     |                        | $          | 61,907                      |       | $                              | 4,446      |             | $          | 288 |   | $ | 116,482 |   |
| Investing  activities                                 |       | (160,497   | )          | (15,387                     | )          | (54,312                     | )          | 212                            |       | (229,984         | )          |
| Financing  activities                                 |       | 110,952    |       | (47,101                     | )          | 52,962                      |       | (500                           | )          | 116,313          |       |
|                                                  |       |       |       |                        |       |                        |       |                           |       |             |       |
| Net increase  (decrease) in cash and cash equivalents |       | 296        |       | (581                        | )          | 3,096                       |       | —                         |       | 2,811            |       |
|                                                  |       |       |       |                        |       |                        |       |                           |       |             |       |
|                                                  |       |       |       |                        |       |                        |       |                           |       |             |       |
| Cash at  beginning of  the period                |       | 4,302      |       | 1,633                       |       | —                      |       | —                         |       | 5,935            |       |
|                                                  |       |       |       |                        |       |                        |       |                           |       |             |       |
| Cash at end of  the period                            |       | $          | 4,598      |                        | $          | 1,052                       |       | $                              | 3,096      |             | $          | — |   | $ | 8,746 |   |

** **

**Condensed Consolidating Statement of Cash FlowsNine Months Ended September 30, 2005****(Unaudited)(Dollars in thousands)**
| ** **                                            | ** ** | **Issuer** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-Guarantor  Entities** | ** ** | **Adjustments/  Eliminations** | ** ** | **Consolidated** | ** ** |
|-------------------------------------------------------|------------|------------|------------|-----------------------------|------------|-----------------------------|------------|--------------------------------|------------|------------------|------------|
|                                                  |       |       |       |                        |       |                        |       |                           |       |             |       |
| Operating  activities                                 |       | $          | 93,442     |                        | $          | 33,189                      |       | $                              | —     |             | $          | — |   | $ | 126,631 |   |
| Investing  activities                                 |       | (79,141    | )          | (35,731                     | )          | —                      |       | —                         |       | (114,872         | )          |
| Financing  activities                                 |       | 31,455     |       | (9,059                      | )          | —                      |       | —                         |       | 22,396           |       |
|                                                  |       |       |       |                        |       |                        |       |                           |       |             |       |
| Net increase  (decrease) in cash and cash equivalents |       | 45,756     |       | (11,601                     | )          | —                      |       | —                         |       | 34,155           |       |
|                                                  |       |       |       |                        |       |                        |       |                           |       |             |       |
| Cash at  beginning of the period                      |       | 2,732      |       | 13,627                      |       | —                      |       | —                         |       | 16,359           |       |
|                                                  |       |       |       |                        |       |                        |       |                           |       |             |       |
| Cash at end of the  period                            |       | $          | 48,488     |                        | $          | 2,026                       |       | $                              | —     |             | $          | — |   | $ | 50,514 |   |

 

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**Item 2-**                      Management’sDiscussion and Analysis of Financial Condition and Results of Operations

The following discussion is intended to provide information relevant toan understanding of our financial condition, changes in our financial conditionand our results of operations and cash flows and should be read in conjunctionwith our consolidated financial statements and notes thereto included elsewherein this Form 10-Q and in our Form 10-K for the year endedDecember 31, 2005.

**Overview**

We are an oil and natural gas exploration,development, acquisition and production company.  Our basic business model is to find anddevelop oil and gas reserves through exploration and development activities,and sell the production from those reserves at a profit.  To be successful, we must, over time, be ableto find oil and gas reserves and then sell our discovered production at a pricethat is sufficient to cover our finding costs, operating expenses,administrative costs and interest expense, plus offer us a return on ourcapital investment.  From time totime, we may also acquire producing properties if we believe the acquiredassets offer us the potential for reserve growth through additionaldevelopmental or exploratory drilling activities.

We believe that the economic climate in thedomestic oil and gas industry continues to be suitable for our businessmodel.  Oil and gas prices have remainedstrong.  Supply and demand fundamentalscontinue to suggest that energy prices will remain high for the near term,providing us with the economic incentives necessary for us to assume the riskswe face in our search for oil and gas reserves.  On thedownside, however, we are also experiencing significant cost increases inalmost all areas of our business activities, especially in drilling andproduction costs.  High demand foroilfield services is being met with shortages in equipment and trainedpersonnel, resulting in rate increases. While profit margins still remain favorable, operating metrics per Mcfe,such as finding costs, production costs and overhead costs, are rising.

**KeyFactors to Consider**

The following summarizes the key factorsconsidered by management in the review of our financial condition and operatingperformance for the third quarter of 2006 and the outlook for the remainder of2006.

·            We have spent$183.4 million on exploration and development activities during the firstnine months of 2006, most of which was on exploratory prospects, and wecurrently plan to spend approximately $244.3 million for the calendar year2006.  These levels of expenditures aresignificantly higher than our anticipated cash flow from operations in 2006.

·            We increasedborrowings under our revolving credit facility from $90.4 million atJune 30, 2006 to $104.4 million at September 30, 2006 to partiallyfinance our exploration and development activities.  Borrowings have increased $93.7 million fromlevels at December 31, 2005.

·            Despite ourhigh level of capital spending in 2006, our average daily oil and gasproduction for the third quarter of 2006 was 3% lower on an Mcfe basis than thecorresponding period in 2005.  Asignificant portion of these expenditures have not resulted in currentproduction because they relate to (i) unproved exploratory prospects, (ii)drilling or completion activities that are in progress, or (iii) non-productivedrilling.

·            AtSeptember 30, 2006, our capitalized unproved oil and gas propertiestotaled $150.8 million, of which approximately $100.7 million wasattributable to unproved 

23

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                  acreage.  Unproved properties are subject to avaluation impairment to the extent the carrying cost of a prospect exceeds itsestimated fair value.  Therefore, ourresults of operations in future periods may be adversely affected by unprovedproperty impairments.

·            Exploration costs related to abandonmentsand impairments were $19.7 million during the third quarter of 2006, of which$8.1 million was attributable to the Apache Louisiana Minerals 73-1 (Abigail)in South Louisiana, $5.9million was due to two exploratory wells on the Focus Ranch unit in Colorado,$2.9 million was due to acreage impairments in West Texas and $2.1 millionwas attributable to the Weyerhaeuser #1 (Frazier Creek) in North Louisiana.

·            We recorded a $26.7 million net gain onderivatives during the third quarter of 2006. Cash settlements tocounterparties accounted for a $1.7 million loss and changes inmark-to-market valuations accountedfor a $28.4 million gain.  Since wedo not presently designate our derivatives as cash flow hedges under applicableaccounting standards, we recognize the full effect of changing prices onmark-to-market valuations as a current charge or credit to our results ofoperations.

·            We recorded a$12.9 million impairment of proved properties during the third quarter of 2006due to the combined effects of lower commodity prices and lower reserveestimates.  The impairment applied to twoareas within West Texas and one area in South Louisiana.

**RecentExploration and Developmental Activities**

***Overview***

As shown in “Liquidity and Capital Resources —Capital Expenditures,” we incurred expenditures for exploration and developmentactivities of $183.4 million during the first nine months of 2006.  Approximately 70% of these expenditures werelease purchases and seismic and other exploration costs.

We are actively acquiring leases in NorthLouisiana and East Texas in order to establish a significant acreage positionfor future exploratory and, if successful, developmental drillingactivities.  We believe that the reservepotential in these areas is significant and warrants this investment inacreage.

***South Louisiana***

The following table sets forth certaininformation about our exploratory well activities in South Louisiana subsequentto December 31, 2005.
| ** **    | ** ** | ** **                       | ** ** | **Working**  | ** ** | **Current**                      |
|---------------|------------|----------------------------------|------------|--------------|------------|----------------------------------|
| **Spud Date** | ** ** | **Well Name (Prospect)**         | ** ** | **Interest** | ** ** | **Status**                       |
| January 2006  |       | Borah #1 (Cypress Isle)          |       | 75           | %          | Dry                              |
| February 2006 |       | SL 195 QQ #2 (Floyd)             |       | 81.3         | %          | Producing                        |
| February 2006 |       | SL 195 QQ #3 (Floyd)             |       | 75           | %          | Producing                        |
| March 2006    |       | SL 195 QQ #4 (Floyd)             |       | 72           | %          | Waiting on pipeline              |
| March 2006    |       | A. J. Beshel #1 (Beshel)         |       | 100          | %          | Waiting on production facilities |
| April 2006    |       | Cobena #1 (Boa II)               |       | 62.5         | %          | Waiting on completion            |
| May 2006      |       | SL 195 QQ #5 (Floyd)             |       | 75           | %          | Producing                        |
| June 2006     |       | SL 195 QQ #8 (Floyd)             |       | 70           | %          | Waiting on pipeline              |
| August 2006   |       | SL 195 QQ #6 (Floyd)             |       | 75           | %          | Waiting on pipeline              |
| October 2006  |       | SL 195 QQ #11 (Floyd)            |       | 72           | %          | Waiting on completion            |
| November 2006 |       | Kyle Peterman Mgt #30-1 (Pigeon) |       | 100          | %          | Drilling                         |
| November2006  |       | Luke Harvey #1 (Beshal Shallow)  |       | 100          | %          | Drilling                         |

 

24

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We have completed seven productive wells onour Floyd prospect in Plaquemines Parish. Four of the wells are currently producing at combined rates of 290barrels of oil per day and 16,100 Mcf of gas per day.  The remaining wells are expected to beginproduction during the fourth quarter of 2006 at combined rates of approximately650 barrels of oil per day and 6,000 Mcf of gas per day, based on availablewell test data.  One additional well iswaiting on completion, and we may drill up to four additional wells on thisprospect, depending on a performance evaluation of existing wells.  Under the terms of a farmout agreement, webear 100% of the cost of wells on this prospect to casing point and earn up toa 75% working interest in the drilled acreage.

We have drilled and logged the Cobena #1 (BoaII), a 15,250-foot exploratory well in Acadia Parish, and have encounteredmultiple pay zones with encouraging gas shows. We bear 50% of the cost of this well to casing point and 62.5%thereafter.  To date, we have incurredapproximately $8 million in drilling and completion costs, net to our interest.

We drilled and abandoned the Apache LouisianaMinerals 73-1 (Abigail), a 14,200-foot exploratory well in Terrebonne Parishafter determining that the well was nonproductive.  We recorded a pre-tax charge of $8.1 millionrelated to the abandonment of this well in the third quarter of 2006 and willrecord an additional pre-tax charge of approximately $3.2 million in the fourthquarter of 2006.

***North Louisiana***

We have drilled two exploratory wells on ourFrazier Creek prospect in Claiborne Parish targeting the Hosston/Cotton Valleyformations.  The Atkins Estate #1 wascompleted as a marginal producer and the Weyerhaeuser #1 was not productive.  We recorded a pre-tax charge of $2.1 millionrelated to the abandonment of the Weyerhaeuser well in the third quarter of2006 and will record an additional pre-tax charge of approximately $1 millionin the fourth quarter of 2006.  We own a100% working interest in both wells on this prospect.

On our Terryville prospect in Lincoln Parish,we have drilled and logged the Roberson #1 well and have encounteredencouraging gas shows in two Cotton Valley sand intervals.  Completion operations on this exploratorywell are expected to begin in November pending the availability of a completionrig.  In addition, we are currentlydrilling the Donald Woodard #1 on this prospect.  We will own between 71% and 100% of theworking interests in these wells, depending on participation elections by otherowners.

In addition, we have begun drillingoperations on the P. Benoit #1, the first exploratory well on our Seraptaprospect in Webster Parish targeting the Hosston/Cotton Valley formations.

We have delayed the start of our Bossierexploration program in North Louisiana until the first quarter of 2007 due torig scheduling.  To date, we have leasedapproximately 165,000 net acres in this area for potential Bossier drillingactivities.

***Other***

We have also delayed the start of our EastTexas Bossier exploration program until the first quarter of 2007 due to rigscheduling.  To date, we have leasedapproximately 47,000 net acres in this area for potential Bossier drillingactivities.

We have drilled two wells in Routt County,Colorado targeting the Niobraro formation at a depth of approximately 8,500feet.  The Focus RanchFederal 12 #1 and the Focus Ranch Federal 3-1 have been temporarilyabandoned.  As a result, we recorded apre-tax charge of $5.9 million related to the 

25

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abandonments in the third quarter of 2006 andwill record an additional pre-tax charge of approximately $1.4 million inthe fourth quarter of 2006.  We own a100% working interest in both wells on this prospect.

**SupplementalInformation**

The followingunaudited information is intended to supplement the consolidated financialstatements included in this Form 10-Q with data that is not readily availablefrom those statements.
| ** **                                              | ** ** | **Three Months Ended** | ** ** |
|---------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                              | ** ** | **September 30,**           | ** ** |
| ** **                                              | ** ** | **2006**                         | ** ** | **2005** | ** ** |
| **Oil and  Gas Production Data:**                       | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Gas (MMcf)                                              |       | 3,738                            |       | 3,897 |   |
| Oil (MBbls)                                             |       | 532                              |       | 537 |   |
| Natural gas liquids (MBbls)                             |       | 51                               |       | 52 |   |
| Total (MMcfe)                                           |       | 7,236                            |       | 7,431 |   |
| **Average  Realized Prices (a):**                       | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Gas ($/Mcf)                                             |       | $                                | 6.26       |   | $ | 7.98 |   |
| Oil ($/Bbl)                                             |       | $                                | 67.27      |   | $ | 59.95 |   |
| Natural gas liquids ($/Bbl):                            |       | $                                | 43.79      |   | $ | 37.00 |   |
| **Gain  (Losses) on Settled Derivative Contracts (a):** | ** ** | ** **                       | ** ** | ** ** | ** ** |
| ($in thousands, except per unit)                        |       |                             |       |   |   |
| Gas: Net realized gain (loss)                           |       | $                                | 5,543      |   | $ | (2,023 | ) |
| Per unit produced ($/Mcf)                               |       | $                                | 1.48       |   | $ | (0.52 | ) |
| Oil:  Net  realized loss                           |       | $                                | (7,328     | ) | $ | (5,935 | ) |
| Per unit produced ($/Bbl)                               |       | $                                | (13.77     | ) | $ | (11.05 | ) |
| **Average  Daily Production:**                          | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Natural Gas (Mcf):                                      |       |                             |       |   |   |
| Permian Basin                                           |       | 13,804                           |       | 17,300 |   |
| Louisiana                                               |       | 15,059                           |       | 8,528 |   |
| Austin Chalk (Trend)                                    |       | 2,102                            |       | 2,672 |   |
| Cotton Valley Reef Complex                              |       | 9,083                            |       | 13,336 |   |
| Other                                                   |       | 582                              |       | 523 |   |
| Total                                                   |       | 40,630                           |       | 42,359 |   |
| Oil (Bbls):                                             |       |                             |       |   |   |
| Permian Basin                                           |       | 3,102                            |       | 3,131 |   |
| Louisiana                                               |       | 899                              |       | 809 |   |
| Austin Chalk (Trend)                                    |       | 1,719                            |       | 1,839 |   |
| Other                                                   |       | 63                               |       | 58 |   |
| Total                                                   |       | 5,783                            |       | 5,837 |   |
| Natural Gas  Liquids (Bbls):                            |       |                             |       |   |   |
| Permian Basin                                           |       | 230                              |       | 261 |   |
| Austin Chalk (Trend)                                    |       | 260                              |       | 220 |   |
| Other                                                   |       | 64                               |       | 84 |   |
| Total                                                   |       | 554                              |       | 565 |   |

 

(Continued)

26

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| ** **                                | ** ** | **Three Months Ended** | ** ** |
|-------------------------------------------|------------|----------------------------------|------------|
| ** **                                | ** ** | **September 30,**           | ** ** |
| ** **                                | ** ** | **2006**                         | ** ** | **2005** | ** ** |
| **Exploration  Costs (in thousands):**    | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Abandonment and impairment costs:         |       |                             |       |   |   |
| Louisiana                                 |       | $                                | 10,863     |   | $ | 9,434 |   |
| Permian Basin                             |       | 2,850                            |       | 72 |   |
| Colorado                                  |       | 5,924                            |       | — |   |
| Mississippi                               |       | —                           |       | 915 |   |
| Cotton Valley Reef Complex                |       | 13                               |       | 5 |   |
| Other                                     |       | —                           |       | 3,437 |   |
| Total                                     |       | 19,650                           |       | 13,863 |   |
| Seismic and other                         |       | 3,678                            |       | 5,123 |   |
| Total exploration costs                   |       | $                                | 23,328     |   | $ | 18,986 |   |
| **Oil and  Gas Costs ($/Mcfe Produced):** |       |                             |       |   |   |
| Production costs                          |       | $                                | 2.28       |   | $ | 2.29 |   |
| Oil and gas depletion                     |       | $                                | 2.30       |   | $ | 1.46 |   |
| **Net  Wells Drilled (b):**               |       |                             |       |   |   |
| Exploratory Wells                         |       | 9.1                              |       | 3.7 |   |
| Developmental Wells                       |       | —                           |       | 6.0 |   |
|                                      |       |                             |       |   |   |

 

 
| ** **                                             | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                             | ** ** | **September 30,**          | ** ** |
| ** **                                             | ** ** | **2006**                        | ** ** | **2005** | ** ** |
| **Oil and  Gas Production Data:**                      | ** ** | ** **                      | ** ** | ** ** | ** ** |
| Gas (MMcf)                                             |       | 11,217                          |       | 13,205 |   |
| Oil (MBbls)                                            |       | 1,642                           |       | 1,771 |   |
| Natural gas liquids (MBbls)                            |       | 151                             |       | 185 |   |
| Total (MMcfe)                                          |       | 21,975                          |       | 24,941 |   |
| **Average  Realized Prices(a):**                       | ** ** | ** **                      | ** ** | ** ** | ** ** |
| Gas ($/Mcf)                                            |       | $                               | 6.74       |   | $ | 6.88 |   |
| Oil ($/Bbl)                                            |       | $                               | 64.70      |   | $ | 52.39 |   |
| Natural gas liquids ($/Bbl):                           |       | $                               | 40.15      |   | $ | 31.70 |   |
| **Gain  (Losses) on Settled Derivative Contracts(a):** | ** ** | ** **                      | ** ** | ** ** | ** ** |
| ($in thousands, except per unit)                       |       |                            |       |   |   |
| Gas: Net realized gain (loss)                          |       | $                               | 2,478      |   | $ | (2,585 | ) |
| Per unit produced ($/Mcf)                              |       | $                               | .22        |   | $ | (.20 | ) |
| Oil:  Net  realized loss                          |       | $                               | (19,923    | ) | $ | (14,918 | ) |
| Per unit  produced ($/Bbl)                             |       | $                               | (12.13     | ) | $ | (8.42 | ) |

 

(Continued)

27

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| ** **                                | ** ** | **Nine Months Ended** | ** ** |
|-------------------------------------------|------------|---------------------------------|------------|
| ** **                                | ** ** | **September 30,**          | ** ** |
| ** **                                | ** ** | **2006**                        | ** ** | **2005** | ** ** |
| **Average  Daily Production:**            | ** ** | ** **                      | ** ** | ** ** | ** ** |
| Natural Gas (Mcf):                        |       |                            |       |   |   |
| Permian Basin                             |       | 14,455                          |       | 16,512 |   |
| Louisiana                                 |       | 13,339                          |       | 12,777 |   |
| Austin Chalk (Trend)                      |       | 2,704                           |       | 2,443 |   |
| Cotton Valley Reef Complex                |       | 10,073                          |       | 15,972 |   |
| Other                                     |       | 517                             |       | 666 |   |
| Total                                     |       | 41,088                          |       | 48,370 |   |
| Oil (Bbls):                               |       |                            |       |   |   |
| Permian Basin                             |       | 3,196                           |       | 3,248 |   |
| Louisiana                                 |       | 975                             |       | 1,258 |   |
| Austin Chalk (Trend)                      |       | 1,789                           |       | 1,927 |   |
| Other                                     |       | 55                              |       | 54 |   |
| Total                                     |       | 6,015                           |       | 6,487 |   |
| Natural Gas  Liquids (Bbls):              |       |                            |       |   |   |
| Permian Basin                             |       | 238                             |       | 238 |   |
| Austin Chalk (Trend)                      |       | 271                             |       | 316 |   |
| Other                                     |       | 44                              |       | 124 |   |
| Total                                     |       | 553                             |       | 678 |   |
| **Exploration  Costs (in thousands):**    |       |                            |       |   |   |
| Abandonment and impairment costs:         |       |                            |       |   |   |
| Louisiana                                 |       | $                               | 21,749     |   | $ | 10,911 |   |
| Permian Basin                             |       | 5,167                           |       | 1,042 |   |
| Colorado                                  |       | 5,924                           |       | — |   |
| Montana                                   |       | 2,230                           |       | — |   |
| Mississippi                               |       | 679                             |       | 4,262 |   |
| Cotton Valley Reef Complex                |       | 27                              |       | 7,405 |   |
| Other                                     |       | 46                              |       | 7,943 |   |
| Total                                     |       | 35,822                          |       | 31,563 |   |
| Seismic and other                         |       | 9,366                           |       | 7,576 |   |
| Total exploration costs                   |       | $                               | 45,188     |   | $ | 39,139 |   |
| **Oil and  Gas Costs ($/Mcfe Produced):** |       |                            |       |   |   |
| Production costs                          |       | $                               | 2.16       |   | $ | 1.74 |   |
| Oil and gas depletion                     |       | $                               | 2.08       |   | $ | 1.36 |   |
| **Net  Wells Drilled(b):**                |       |                            |       |   |   |
| Exploratory Wells                         |       | 21.9                            |       | 11.3 |   |
| Developmental  Wells                      |       | 1.7                             |       | 21.9 |   |

----

(a)             Noderivatives were designated as cash flow hedges in 2006 or 2005.  All gains or losses on settled derivativeswere included in loss on derivatives.

(b)            Excludeswells being drilled or completed at the end of each period.

 

28

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**Operating Results — Three-Month Periods**

The following discussion compares our resultsfor the three months ended September 30, 2006 to the comparative period in2005.  Unless otherwise indicated,references to 2006 and 2005 within this section refer to the respectivequarterly period.

***Oil and gas operating results***

Oil and gas sales in 2006 decreased$4.2 million, or 6%, from 2005, of which price variances accounted for a$2.2 million decrease and production variances accounted for a$2 million decrease.

Production in 2006 (on an Mcfe basis) was 3%lower than 2005.  Oil productiondecreased 1% in 2006 from 2005 due primarily to normal production declines,offset in part by higher production from new wells in Louisiana.  Gas production decreased 4% in 2006 from 2005due primarily to higher than normal production declines in the Permian Basinand Cotton Valley Reef Complex area caused by well performance.

In 2006, our realized oil price was 12%higher than 2005, while our realized gas price was 22% lower.  Historically, the markets for oil and gashave been volatile, and they are likely to continue to be volatile.

Oil and gas production costs on an Mcfe basisdecreased from $2.29 per Mcfe in 2005 to $2.28 per Mcfe in 2006.  Production costs, consisting of lease operatingexpenses, production taxes and other miscellaneous marketing costs, declined 3%in 2006 as compared to 2005 due primarily to reduced workover activities andlower production taxes.  After givingeffect to a 3% decline in oil and gas production on an Mcfe basis, productioncosts per Mcfe changed only slightly.

Depreciation, depletion, and amortization (“DD&A”)expense increased from $11.6 million in 2005 to $17.7 million in2006.  DD&A expense attributable tooil and gas properties increased $5.8 million, of which rate variancesaccounted for a $6.1 million increase and production variances accountedfor a $300,000 decrease.  On an Mcfebasis, DD&A expense increased 58% from $1.46 per Mcfe in 2005 to $2.30 perMcfe in 2006.  Depletion rates for each depletablegroup are a function of net capitalized costs and estimated reserve quantities.

We recorded a provision for impairment ofproved properties under SFAS 144 of $12.9 million during the third quarter of2006 due to the combination of production performance and lower commodityprices.  This provision was attributableto two areas in West Texas and one area in South Louisiana.

General and administrative (“G&A”)expenses, excluding non-cash employee compensation, decreased from$3.6 million in 2005 to $3.1 million in 2006 due primarily to lowerprofessional fees during 2006.  In 2006,we recorded a $500,000 non-cash compensation charge related to our after payoutincentive plan compared to a $1.9 million non-cash charge in 2005 forstock-based employee compensation.

***Explorationcosts***

Since we follow the successful efforts methodof accounting, our results of operations are adversely affected during anyaccounting period in which significant seismic costs, exploratory dry holecosts, and unproved acreage impairments are expensed.  In 2006, we chargedto expense $23.3 million of exploration costs, as compared to$19 million in 2005.  Most of these costs were related to propertiesin Louisiana.

29

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We plan to spend approximately$244.3 million on exploration and development activities in fiscal 2006,of which approximately 87% is expected to be allocated to explorationactivities.  Since exploratory drilling involves a high degree of risk, itis likely that a significant portion of the remaining costs in fiscal 2006 willbe charged to exploration costs. However, we cannot predict our success ratesand, accordingly, cannot predict our exploration costs related to abandonmentand impairment costs.

At September 30, 2006, our capitalizedunproved oil and gas properties totaled $150.8 million, of whichapproximately $100.7 million was attributable to unproved acreage.  Unproved properties are subject to avaluation impairment to the extent the carrying cost of a prospect exceeds itsestimated fair value.  Therefore, ourresults of operations in future periods may be adversely affected by unprovedproperty impairments.

***Interest expense***

Interest expense decreased from$5.5 million in 2005 to $5.3 million in 2006 due to severalfactors.  In July 2005, we issued $225million of 73⁄4% Senior Notes due 2013 (the “Senior Notes”) which bear interestat a fixed rate of 7.75%, and used the proceeds to repay our then-outstandingbank indebtedness.  As a result, the 2005period included a non-cash charge of $1.8 million of debt issue costs relatedto the early repayment of our senior term credit facility and the reduction inour borrowing base under the revolving credit facility.  The average daily principal balanceoutstanding under our bank credit facility for 2006 was $102.6 millioncompared to $40.4 million for 2005, and the Senior Notes were outstandingfor the entire 2006 period.  Capitalizedinterest for 2006 was $1.6 million compared to $727,000 in 2005.

***Gain/loss on derivatives***

We recorded a net gain on derivatives of$26.7 million in 2006 compared to a loss of $28.8 million for 2005.  We did not designate any derivative contractsin 2006 or 2005 as cash flow hedges; therefore all cash settlements and changesresulting from mark-to-market valuations have been recorded as losses onderivatives.  Cash settlements were$1.7 million in 2006, as compared to $8 million in 2005.  We recorded a gain on derivatives of$28.4 million in 2006 compared to a loss of $20.8 million in 2005resulting from mark-to-market valuations.

**Operating Results — Nine-Month Periods**

The following discussion compares our resultsfor the nine months ended September 30, 2006 to the comparative period in2005.  Unless otherwise indicated,references to 2006 and 2005 within this section refer to the respective nine-monthperiod.

***Oil and gas operating results***

Oil and gas sales in 2006 decreased$2.4 million, or 1%, from 2005, of which price variances accounted for a$20 million increase and production variances accounted for a$22.4 million decrease.

Production in 2006 (on an Mcfe basis) was 12%lower than 2005.  Oil productiondecreased 7% in 2006 from 2005 due primarily to normal production declinescombined with the loss of production from one well in Louisiana.  Gas production decreased 15% due primarily toproduction declines in the Cotton Valley Reef Complex area due to formationperformance.

30

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In 2006, our realized oil price was 23%higher than 2005, while our realized gas price was 2% lower.  Historically, the markets for oil and gashave been volatile, and they are likely to continue to be volatile.

Production costs, consisting of leaseoperating expenses, production taxes and other miscellaneous marketing costs,increased 9% in 2006 as compared to 2005 due primarily to higher oilfieldservice costs and increased workover activities.  After giving effect to a 12% decline in oiland gas production on an Mcfe basis, production costs per Mcfe increased 24%from $1.74 per Mcfe in 2005 to $2.16 per Mcfe in 2006.  It is likely that these factors will continueto contribute to higher production costs in future periods.

DD&A expense increased from$36.1 million in 2005 to $48.4 million in 2006.  DD&A expense attributable to oil and gasproperties increased $11.8 million, of which rate variances accounted fora $15.9 million increase and production variances accounted for a$4.1 million decrease.  On an Mcfebasis, DD&A expense increased 53% from $1.36 per Mcfe in 2005 to $2.08 perMcfe in 2006.  Depletion rates for eachdepletable group are a function of net capitalized costs and estimated reservequantities.

We recorded a provision for impairment ofproved properties under SFAS 144 of $12.9 million during 2006 due to thecombination of production performance and lower commodity prices.  This provision was attributable to two areasin West Texas and one area in South Louisiana.

G&A expenses, excluding non-cash employeecompensation, increased from $9 million in 2005 to $11.4 million in2006 due to higher personnel costs and professional fees attributable to theincrease in overall drilling and exploration activities.  In 2006, we recorded a $1.5 millionnon-cash compensation charge related to our after payout incentive plancompared to a $2.1 million non-cash charge in 2005 for stock-based employeecompensation.

***Gain on propertysales***

Gain on sales of property and equipment in2006 was $916,000 as compared to $18.9 million in 2005.  Most of the gain in 2005 related to the saleof our interests in two leases in the Breton Sound area of the Gulf of Mexico.

***Explorationcosts***

Since we follow the successful efforts methodof accounting, our results of operations are adversely affected during anyaccounting period in which significant seismic costs, exploratory dry holecosts, and unproved acreage impairments are expensed.  In 2006, we chargedto expense $45.2 million of exploration costs, as compared to$39.1 million in 2005.  Most of these costs were incurred inLouisiana, the Permian Basin and Montana.

We plan to spend approximately$244.3 million on exploration and development activities in fiscal 2006,of which approximately 87% is expected to be allocated to explorationactivities.  Since exploratory drilling involves a high degree of risk, itis likely that a significant portion of the remaining costs in fiscal 2006 willbe charged to exploration costs. However, we cannot predict our success ratesand, accordingly, cannot predict our exploration costs related to abandonmentand impairment costs.

At September 30, 2006, our capitalizedunproved oil and gas properties totaled $150.8 million, of whichapproximately $100.7 million was attributable to unproved acreage.  Unproved properties are subject to avaluation impairment to the extent the carrying cost of a prospect exceeds itsestimated fair value.  

31

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Therefore, our results of operations infuture periods may be adversely affected by unproved property impairments.

***Interest expense***

Interest expense increased from$10.4 million in 2005 to $14.6 million in 2006 due to severalfactors.  In July 2005, we issued $225million of Senior Notes which bear interest at a fixed rate of 7.75%, and usedthe proceeds to repay our then-outstanding bank indebtedness.  As a result, the 2005 period included anon-cash charge of $1.8 million of debt issue costs related to the earlyrepayment of our senior term credit facility and the reduction in our borrowingbase under the revolving credit facility. The average daily principal balance outstanding under our bank creditfacility for 2006 was $75.7 million compared to $134.3 million for2005; however, the Senior Notes were outstanding for the entire 2006period.  Capitalized interest for 2006was $4.4 million compared to $1.4 million in 2005.

***Gain/loss on derivatives***

We recorded a gain on derivatives of$25.4 million in 2006 compared to a loss of $73.7 million for2005.  We did not designate anyderivative contracts in 2006 or 2005 as cash flow hedges; therefore all cashsettlements and changes resulting from mark-to-market valuations have beenrecorded as losses on derivatives.  Cashsettlements were $17.3 million in 2006, as compared to $17.6 millionin 2005.  We recorded a gain onderivatives of $42.7 million in 2006 compared to a loss of $56.1 million in2005 resulting from mark-to-market valuations.

**Liquidity and Capital Resources**

***Overview***

Our primary financial resource is our base ofoil and gas reserves.  We pledge ourproducing oil and gas properties to a group of banks to secure our revolvingcredit facility.  The banks establish aborrowing base by making an estimate of the collateral value of our oil and gasproperties.  We borrow funds on therevolving credit facility as needed to supplement our operating cash flow as afinancing source for our capital expenditure program.  Our ability to fund our capital expenditureprogram is dependent upon the level of product prices and the success of ourexploration program in replacing our existing oil and gas reserves.  If product prices decrease, our operatingcash flow may decrease and the banks may require additional collateral orreduce our borrowing base, thus reducing funds available to fund our capitalexpenditure program.  The effects ofproduct prices on cash flow can be mitigated through the use of commodityderivatives.  If we are unable to replaceour oil and gas reserves through our exploration program, we may also suffer areduction in our operating cash flow and access to funds under the revolvingcredit facility.  Under extremecircumstances, product price reductions or exploration drilling failures couldallow the banks to seek to foreclose on our oil and gas properties, therebythreatening our financial viability.

In July 2005, we reduced our dependence onthe borrowing base established for the revolving credit facility by issuing$225 million of aggregate principal amount of Senior Notes and using thenet proceeds to repay all amounts outstanding on the revolving credit facilityand the senior term credit facility. However, we have recently drawn advances under the revolving creditfacility to partially finance our exploration and development activities.  At September 30, 2006, we had$104.4 million outstanding on the revolving credit facility.

32

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In this section, we will describe our currentplans for capital spending, identify the capital resources available to financeour capital spending, and discuss the principal factors that can affect ourliquidity and capital resources.

***Capital expenditures***

Our planned expenditures for exploration anddevelopment activities during 2006 total $244.3 million, as summarized byarea in the following table.

|                       | ** ** | **Actual**                       | ** ** | **Total**                       | ** ** | ** **        | ** ** |
|-----------------------|------------|----------------------------------|------------|---------------------------------|------------|-------------------|------------|
| ** **            | ** ** | **Expenditures**                 | ** ** | **Planned**                     | ** ** | ** **        | ** ** |
| ** **            | ** ** | **Nine Months**             | ** ** | **Expenditures**                | ** ** | ** **        | ** ** |
| ** **            | ** ** | **Ended**                        | ** ** | **Year Ended**             | ** ** | **Percentage**    | ** ** |
| ** **            | ** ** | **September 30, 2006** | ** ** | **December 31, 2006** | ** ** | **of Total** | ** ** |
| ** **            | ** ** | **(In thousands)**          | ** ** |
| South Louisiana       |       | $                                | 84,800     |                            | $          | 114,000           |       | 47 | % |
| North Louisiana       |       | 36,900                           |       | 54,300                          |       | 22                | %          |
| Permian Basin         |       | 26,300                           |       | 34,500                          |       | 14                | %          |
| East Texas  (Bossier) |       | 20,500                           |       | 23,600                          |       | 10                | %          |
| Utah/Montana          |       | 6,100                            |       | 7,700                           |       | 3                 | %          |
| Austin Chalk  (Trend) |       | 2,500                            |       | 2,700                           |       | 1                 | %          |
| Other                 |       | 6,300                            |       | 7,500                           |       | 3                 | %          |
|                  |       | $                                | 183,400    |                            | $          | 244,300           |       | 100 | % |

 

Our actual expenditures during fiscal 2006may be substantially higher or lower than these estimates since our plans forexploration and development activities may change during the year.  Other factors, such as prevailing productprices and the availability of capital resources, could also increase ordecrease the ultimate level of expenditures during fiscal 2006.

Approximately half of our expenditures forexploration and development activities for the nine months endedSeptember 30, 2006 have been financed through operating cash flow, and theremainder has been financed through borrowings under the revolving creditfacility.  We also expect this trend tocontinue in the fourth quarter of 2006.

Approximately 87% of the planned expendituresrelate to exploratory prospects. Exploratory prospects involve a higher degree of risk than developmentalprospects.  To offset the higher risk, wegenerally strive to achieve a higher reserve potential and rate of return oninvestments in exploratory prospects.  Wedo not attempt to forecast our success rate on exploratory drilling.  Accordingly, these current estimates do notinclude costs we may incur to complete any future successful exploratory wellsand construct the required production facilities for these wells.  Also, we are actively searching for otheropportunities to increase our oil and gas reserves, including the evaluation ofnew prospects for exploratory and developmental drilling activities andpotential acquisitions of proved oil and gas properties.

*Drilling Rig Joint Venture*

In April 2006, we invested $500,000 in a joint venture (“Larclay JV”)with Lariat Services, Inc. (“Lariat”) to construct, own and operate 12 newdrilling rigs.  CWEI and Lariat each owna 50% interest in Larclay JV.  The rigsare being constructed on behalf of Larclay JV by Lariat, as operationsmanager.  Construction of all the rigs isexpected to be completed by February 28, 2007 at a cost of approximately$75 million.  A lender has provideda $75 million secured term loan to Larclay JV to finance the

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the construction and equipping of the rigs.  Pursuant to the term loan, we have issued a$19 million letter of credit to the lender as additional collateral duringthe construction period.  Upon theearlier of compliance with specified collateral ratios or February 28, 2007,the lender will release the letter of credit in exchange for a$19.5 million guaranty from us. After completion of the construction period, outstanding advances underthe term loan must not exceed 75% of the appraised value of the rigs.  If proceeds available to Larclay JV under theterm loan are not sufficient to fully finance the cost of the rigs, we will berequired to loan funds to Larclay JV at the same interest rate as the term loan.  The Larclay JV term loan bears interest at afloating rate based on a LIBOR average, plus 3.25%, and provides for monthlyinterest payments through March 2007 and monthly principal and interestpayments thereafter sufficient to retire the principal balance by 35% in thefirst year, 25% in each of the next two years, and 15% in the fourth year.  At September 30, 2006, the effectiveinterest rate on the Larclay JV term loan was 8.5%.  Two voluntary prepayments of $10 million eachmay be made in 2008 and 2009 without a prepayment penalty.  The Larclay JV term loan prohibits Larclay JVfrom making any cash distributions to us or to Lariat until the balance on theterm loan is fully repaid, and repayments by Larclay JV of any loans by us orby Lariat are subordinated to the loans outstanding under the term loan and aresubject to other restrictions.

Also in April 2006, we entered into a three-year drilling contract withLarclay JV assuring the availability of each rig for use in the ordinary courseof our exploration and development drilling program throughout the term of thedrilling contract.  The provisions of thedrilling contract require that we contract for each rig on a well-by-well basisat then current market rates.  If a rigis not needed by us at any time during the term of the contract, Larclay JV maycontract with Lariat, affiliates of Lariat or other third party operators forthe use of such rig, subject to certain restrictions.  If a rig is idle, we will pay Larclay JV anidle rig rate ranging from $8,100 per day to $10,300 per day (plus crew laborexpenses, if applicable), depending on the size of the rig.

Our gross idle rig commitment under thedrilling contract with Larclay JV, excluding crew labor, if any, aggregatesapproximately $112 million over the three-year term of the contract.  Fourrigs are currently operational, of which two are working for us and two areworking for other operators.  We plan to mitigate our exposure to our idlerig commitment by permitting Larclay JV to contract with other operators toutilize specific rigs which we do not expect to use in our drillingprogram.  As we utilize the Larclay JVrigs in the ordinary course of our drilling program, the cost of such rigs willbe included in our exploration and development expenditures.

In addition to the rigs we have committed touse pursuant to the drilling contract with Larclay JV described above, we aredirectly committed under firm orders for two drilling rigs and relatedequipment in an aggregate amount of $24.5 million, of which cash depositstotaling $8.1 million have been paid to certain equipment suppliers as ofSeptember 30, 2006.  The total costof the rigs, when completed and fully equipped, will be approximately$27 million.  The rigs are scheduledfor delivery in mid-2007 and are expected to be utilized to drill our deepBossier prospects in East Texas and North Louisiana.

We have also entered into two drilling contracts with third partydrilling contractors and are obligated to make payments under these contractstotaling $11 million in the fourth quarter of 2006 and $25 million in2007.

***Cash flow provided by operating activities***

Substantially all of our cash flow fromoperating activities is derived from the production of our oil and gasreserves.  We use this cash flow to fundour on-going exploration and development activities in 

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search of new oil and gas reserves.  Variations in cash flow from operatingactivities may impact our level of exploration and development expenditures.

Cash flow provided by operating activitiesfor the nine months ended September 30, 2006 decreased $10.1 million, or8%, as compared to the corresponding period in 2005 due to the combined effectsof several factors.  Oil and gas sales,net of production costs, general and administrative costs and interest expense,were $10.8 million lower in 2006 as compared to the same period in2005.  Our primary source of cash fromoperating activities is our oil and gas sales, net of production costs.  Our cash flow provided by operatingactivities is subject to material variation from changes in oil and gasproduction levels and product prices. Settlements on derivative contracts, excluding those contracts thatcontain a financing element as in the case of the contracts assumed in ouracquisition of Southwest Royalties, Inc. in May 2004, were substantially thesame in both periods.  Interest expenseincreased in 2006 due primarily to higher levels of indebtedness resulting fromthe issuance of the Senior Notes.

***Credit facility***

A group of banks have provided us with arevolving credit facility on which we have historically relied for both ourshort-term liquidity (working capital) and our long-term financing needs.  The funds available to us at any time underthis revolving credit facility are limited to the amount of the borrowing baseestablished by the banks.  As long as wehave sufficient availability under this credit facility to meet our obligationsas they come due, we will have sufficient liquidity and will be able to fundany short-term working capital deficit.

At the beginning of 2006, we had anoutstanding balance under the revolving credit facility of $10.7 million,and the borrowing base was $150 million, providing us with available fundsof $138.5 million after accounting for outstanding letters of credit.  In June 2006, the borrowing base wasincreased to $200 million.  During thenine months ended September 30, 2006, we generated cash flow from operatingactivities of $116.5 million.  Wealso spent $183.9 million on capital expenditures and other investments(excluding Larclay JV) and paid $23.3 million to settle derivatives withfinancing elements.  To finance theexcess of expenditures over cash flow, we borrowed $93.7 million on therevolving credit facility.

Using the revolving credit facility forboth our short-term liquidity and long-term financing needs can cause unusualfluctuations in our reported working capital, depending on the timing of cashreceipts and expenditures.  On a dailybasis, we use most of our available cash to pay down our outstanding balance onthe revolving credit facility, which is classified as a non-current liabilitysince we currently have no required principal reductions.  As we use cash to pay a non-currentliability, our reported working capital decreases.  Conversely, as we draw on the revolvingcredit facility for funds to pay current liabilities (such as payables fordrilling and operating costs), our reported working capital increases.  Also, volatility in oil and gas prices cancause significant fluctuations in reported working capital as we record changesin the fair value of derivatives from period to period.  For these reasons, the working capitalcovenant related to the revolving credit facility requires us to(i) include the amount of funds available under this facility as a currentasset, (ii) exclude current assets and liabilities related to the fairvalue of derivatives, and (iii) exclude current maturities of vendor financeobligations, if any, when computing the working capital ratio at any balancesheet date.

Working capital computed for loan compliancepurposes differs from our working capital in accordance with generally acceptedaccounting principles (GAAP).  Sincecompliance with financial covenants is a material requirement under the creditfacilities, we consider the loan compliance working 

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capital to be useful as a measure of ourliquidity because it includes the funds available to us under the revolvingcredit facility and is not affected by the volatility in working capital causedby changes in fair value of derivatives. Our reported working capital deficit decreased from $35.8 millionat December 31, 2005 to $27 million at September 30, 2006 dueprimarily to a combination of factors, including decreases in accounts payableand increases in inventory.  After givingeffect to the adjustments, our working capital computed for loan compliancepurposes was a positive $62.1 million at September 30, 2006, as comparedto a positive $136.2 million at December 31, 2005.  The following table reconciles our GAAPworking capital to the working capital computed for loan compliance purposes atSeptember 30, 2006 and December 31, 2005.

|                                                                                        | ** ** | **September 30,**  | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------|------------|
| ** **                                                                             | ** ** | **2006**                | ** ** | **2005**              | ** ** |
| ** **                                                                             | ** ** | **(In thousands)** | ** ** |
| Working capital  (deficit) per GAAP                                                    |       | $                       | (27,012    | )                     | $          | (35,812 | ) |
| Add funds  available under the revolving credit facility                               |       | 75,796                  |       | 138,496               |       |
| Exclude fair  value of derivatives classified as current assets or current liabilities |       | 13,316                  |       | 33,479                |       |
| Working capital per  loan covenant                                                     |       | $                       | 62,100     |                  | $          | 136,163 |   |

 

Since we use this revolvingcredit facility for both short-term liquidity and long-term financing needs, itis important that we comply in all material respects with the loan agreement,including financial covenants that are computed quarterly.  The working capital covenant requires us tomaintain positive working capital using the computations described above.  Another financial covenant under the creditfacility requires us to maintain a ratio of indebtedness to cash flow of nomore than 3 to 1.  While we were incompliance with all financial and non-financial covenants at September 30, 2006,our increased leverage and reduced liquidity may result in our failing tocomply with one or more of these covenants in the future.  If we fail tomeet any of these loan covenants, we would ask the banks to allow us sufficienttime to obtain additional capital resources through alternative means.  If a suitable arrangement could not bereached with the banks, the banks could accelerate the indebtedness and seek toforeclose on the pledged assets.

The banks redeterminethe borrowing base under the revolving credit facility at least twice a year,in May and November.  The May 2006borrowing base review resulted in an increase from $150 million to $200 millionwhich was finalized in September 2006. If at any time, the borrowing base is less than the amount ofoutstanding indebtedness, we will be required to (i) pledge additionalcollateral, (ii) prepay the excess in not more than five equal monthlyinstallments, or (iii) elect to convert the entire amount of outstandingindebtedness to a term obligation based on amortization formulas set forth inthe loan agreement.  We have recentlydrawn advances under the revolving credit facility to partially finance ourexploration and development activities. At September 30, 2006, we had $104.4 million outstanding on therevolving credit facility.

***7*****3****¤****4%Senior Notes due 2013**

In July 2005, we issued, in a private placement,$225 million of aggregate principal amount of Senior Notes.  The Senior Notes were issued at face valueand will bear interest at 73**¤*****4***% per year, payable semi-annually onFebruary 1 and August 1 of each year, beginning February 1, 2006.  After the payment of typical transactionexpenses, net proceeds of approximately $217 million were used to repayamounts outstanding on our secured credit facilities and for general corporatepurposes, including the funding of planned exploration and developmentactivities.

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At any time prior to August 1, 2008, we may redeem upto 35% of the aggregate principal amount of the Senior Notes with the proceedsof certain equity offerings at a redemption price of 107.75% of the principalamount, plus accrued and unpaid interest. In addition, prior to August 1, 2009, we may redeem some or all of theSenior Notes at a redemption price equal to 100% of the principal amount of theSenior Notes to be redeemed, plus a make-whole premium, plus any accrued andunpaid interest.  On and after August 1,2009, we may redeem some or all of the Senior Notes at redemption prices(expressed as percentages of principal amount) equal to 103.875% for thetwelve-month period beginning on August 1, 2009, 101.938% for thetwelve-month period beginning on August 1, 2010, and 100.00% beginning onAugust 1, 2011, for any period thereafter, in each case plus accrued and unpaidinterest.

The Indenture governing the Senior Notes restricts ourability and the ability of our restricted subsidiaries to:  (i) borrow money; (ii) issueredeemable and preferred stock; (iii) pay distributions or dividends;(iv) make investments; (v) create liens without securing the Notes;(vi) enter into agreements that restrict dividends from subsidiaries;(vii) sell certain assets or merge with or into other companies;(viii) enter into transactions with affiliates; (ix) guaranteeindebtedness; and (x) enter into new lines of business.  These covenants are subject to a number ofimportant exceptions and qualifications. We were in compliance with these covenants at September 30, 2006.

***Alternative capital resources***

Although our base of oil and gas reserves, ascollateral for both of our credit facilities, has historically been our primarycapital resource, we have in the past, and we believe we could in the future,use alternative capital resources, such as asset sales, vendor financingarrangements, and/or public or private issuances of common stock.  We could also issue senior or subordinateddebt or preferred stock in a public or a private placement if we choose toraise capital through either of these markets. While we believe we would be able to obtain funds through one or more ofthese alternatives, if needed, there can be no assurance that these capitalresources would be available on terms acceptable to us.

**Item 3 -**      Quantitative and QualitativeDisclosure About Market Risks

Our business is impacted by fluctuations incommodity prices and interest rates.  Thefollowing discussion is intended to identify the nature of these market risks,describe our strategy for managing such risks, and to quantify the potentialaffect of market volatility on our financial condition and results ofoperations.

**Oil and Gas Prices**

Our financial condition, results ofoperations, and capital resources are highly dependent upon the prevailingmarket prices of, and demand for, oil and natural gas.  These commodity prices are subject to widefluctuations and market uncertainties due to a variety of factors that arebeyond our control.  These factorsinclude the level of global demand for petroleum products, foreign supply ofoil and gas, the establishment of and compliance with production quotas byoil-exporting countries, weather conditions, the price and availability ofalternative fuels, and overall economic conditions, both foreign anddomestic.  We cannot predict future oiland gas prices with any degree of certainty. Sustained weakness in oil and gas prices may adversely affect ourfinancial condition and results of operations, and may also reduce the amountof net oil and gas reserves that we can produce economically.  Any reduction in reserves, includingreductions due to price fluctuations, can reduce the borrowing base under ourrevolving credit facility and 

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adversely affect our liquidity and ourability to obtain capital for our exploration and development activities.  Similarly, any improvements in oil and gasprices can have a favorable impact on our financial condition, results ofoperations and capital resources.  Basedon December 31, 2005 reserve estimates, we project that a $1.00 drop inthe price per Bbl of oil and a $.50 drop in the price per Mcf of gas wouldreduce our gross revenues for the year ending December 31, 2006 by$11 million.

From time to time, we utilize commodityderivatives, consisting primarily of swaps, floors and collars to attempt tooptimize the price received for our oil and natural gas production.  When using swaps to hedge our oil and naturalgas production, we receive a fixed price for the respective commodity and pay afloating market price as defined in each contract (generally NYMEX futuresprices), resulting in a net amount due to or from the counterparty.  In floor transactions, we receive a fixedprice (put strike price) if the market price falls below the put strike pricefor the respective commodity.  If themarket price is greater than the put strike price, no payments are due fromeither party.  Costless collars are acombination of puts and calls, and contain a fixed floor price (put strikeprice) and ceiling price (call strike price). If the market price for the respective commodity exceeds the call strikeprice or falls below the put strike price, then we receive the fixed price andpay the market price.  If the marketprice is between the call and the put strike prices, no payments are due fromeither party.  Commodity derivatives aresettled monthly as the contract periods mature. The commodity derivatives we use differ from futures contracts in thatthere is not a contractual obligation that requires or permits the future physicaldelivery of the hedged products.  We donot enter into commodity derivatives for trading purposes.  In addition to commodity derivatives, we may,from time to time, sell a portion of our gas production under short-termcontracts at fixed prices.

The decision to initiate or terminatecommodity hedges is made by management based on its expectation of futuremarket price movements.  We have no setgoals for the percentage of our production we hedge and we do not use anyformulas or triggers in deciding when to initiate or terminate a hedge.  If we enter into swaps or collars and thefloating market price at the settlement date is higher than the fixed price orthe fixed ceiling price, we will forego revenue we would have otherwisereceived.  If we terminate a swap, collaror floor because we anticipate future increases in market prices, we may beexposed to downside risk that would not have existed otherwise.

The following summarizes informationconcerning our net positions in open commodity derivatives applicable toperiods subsequent to September 30, 2006. The settlement prices of commodity derivatives are based on NYMEXfutures prices.

**Collars:**
| ** **            | ** ** | **Gas**            | ** ** | **Oil**   | ** ** |
|-----------------------|------------|--------------------|------------|-----------|------------|
| ** **            | ** ** | **MMBtu (a)** | ** ** | **Floor** | ** ** | **Ceiling** | ** ** | **Bbls** | ** ** | **Floor** | ** ** | **Ceiling** | ** ** |
| Production  Period:   |       |               |       |      |       |   |   |   |   |   |   |   |   |
| 4th Quarter 2006 |       | 456,000            |       | $         | 4.00       |   | $ | 5.21 |   | 150,000 |   | $ | 23.00 |   | $ | 25.32 |   |
| 2007                  |       | 1,831,000          |       | $         | 4.00       |   | $ | 5.18 |   | 562,000 |   | $ | 23.00 |   | $ | 25.20 |   |
| 2008                  |       | 1,279,000          |       | $         | 4.00       |   | $ | 5.15 |   | 392,000 |   | $ | 23.00 |   | $ | 25.07 |   |
|                  |       | 3,566,000          |       |      |       |   |   | 1,104,000 |   |   |   |   |   |

 

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**Swaps:**
| ** **            | ** ** | **Gas**      | ** ** | **Oil**   | ** ** |
|-----------------------|------------|--------------|------------|-----------|------------|
| ** **            | ** ** | **MMBtu(a)** | ** ** | **Price** | ** ** | **Bbls** | ** ** | **Price** | ** ** |
| Production Period:    |       |         |       |      |       |   |   |   |   |
| 4th Quarter 2006 |       | 1,050,000    |       | $         | 10.03      |   | 75,000 |   | $ | 71.60 |   |
| 2007                  |       | 5,100,000    |       | $         | 9.20       |   | 900,000 |   | $ | 70.06 |   |
| 2008                  |       | 3,600,000    |       | $         | 8.37       |   | 360,000 |   | $ | 69.55 |   |
|                  |       | 9,750,000    |       |      |       | 1,335,000 |   |   |   |

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(a)             OneMMBtu equals one Mcf at a Btu factor of 1,000.

In August 2006, we terminated certainfixed-price gas swaps covering 9,010,000 MMBtu of gas production at an averageprice of $9.26 per Mcf for the period from November 2006 through December2007.  We received cash proceeds of$6.1 million upon termination of these contracts.

In July 2006, we also terminated certainfixed-price oil swaps covering 300,000 barrels at a price of $80.45 perbarrel, from January 2007 through December 2007, resulting in an aggregate lossof approximately $2.4 million, which will be paid to the counterpartymonthly during 2007.

We use a sensitivity analysis technique toevaluate the hypothetical effect that changes in the market value of oil andgas may have on the fair value of our commodity derivatives.  A $1 per barrel change in the price ofoil and a $.50 per MMBtu change in the price of gas would change the fair valueof our commodity derivatives by approximately $9.1 million.

**Interest Rates**

We are party to interest rate swaps that wereacquired in connection with the acquisition of Southwest Royalties, Inc. in May2004.  Under these derivatives, we pay afixed rate for the notional principal balances and receives a floating market ratebased on LIBOR.  The following summarizesinformation concerning our net positions in open interest rate swaps applicableto periods subsequent to September 30, 2006.

 
| ** **                            | ** ** | **Principal** | ** ** | **Fixed  Libor** | ** ** |
|---------------------------------------|------------|---------------|------------|------------------|------------|
| ** **                            | ** ** | **Balance**   | ** ** | **Rates**        | ** ** |
| Period:                               |       |          |       |             |       |
| October 1, 2006 to November 1, 2006   |       | $             | 55,000,000 |             | 4.29       | % |
| November 1, 2006 to November 1, 2007  |       | $             | 50,000,000 |             | 5.19       | % |
| November 1, 2007  to November 1, 2008 |       | $             | 45,000,000 |             | 5.73       | % |

 

The interest rate swaps in the precedingtable expose us to market risks for decreases in interest rates during theperiods shown.

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**Item 4-**                      Controlsand Procedures

#### Disclosure Controls andProcedures

Our Board of Directors has adopted a policydesigned to establish disclosure controls and procedures that are adequate toprovide reasonable assurance that we will be able to collect, process anddisclose both financial and non-financial information, on a timely basis, inour reports to the SEC and other communications with our stockholders.  Disclosure controls and procedures includeall processes necessary to ensure that material information is recorded,processed, summarized and reported within the time periods specified in the SEC’srules and forms, and is accumulated and communicated to our management,including our chief executive and chief financial officers, to allow timelydecisions regarding required disclosures.

With respect to our disclosure controls andprocedures:

·                  We haveevaluated the effectiveness of our disclosure controls and procedures as of theend of the period covered by this report;

·                  This evaluationwas conducted under the supervision and with the participation of ourmanagement, including our chief executive and chief financial officers; and

·                  It is the conclusion of our chiefexecutive and chief financial officers that these disclosure controls andprocedures operate such that material information flows to the appropriatecollection and disclosure points in a timely manner and are effective inensuring that material information is accumulated and communicated to ourmanagement and is made known to the chief executive and chief financialofficers, particularly during the period in which this report was prepared, asappropriate to allow timely decisions regarding required disclosures.

#### **Changes in Internal Control Over FinancialReporting**

No changes in internal control over financialreporting were made during the quarter ended September 30, 2006 that havematerially affected, or are reasonably likely to materially affect, ourinternal control over financial reporting.

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**PART II.  FINANCIAL INFORMATION**

**Item 1A-**             Risk Factors

In evaluating all forward-lookingstatements, you should specifically consider various factors that may causeactual results to vary from those contained in the forward-lookingstatements.  Our risk factors areincluded in our Annual Report on Form 10-K for the year endedDecember 31, 2005, as filed with the U.S. Securities and ExchangeCommission on March 16, 2006 and available at www.sec.gov.  There have been no material changes to theserisk factors since the filing of our Form 10-K.

**Item 6-**                      Exhibits
| Exhibits | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
|----------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1**    |       | Second Restated Certificate of Incorporation of the  Company, filed as Exhibit 3.1 to our Form S-2 Registration Statement,  Commission File No. 333-13441                                                                                                                                                                                                                                                                                                                                                                                                             |
|     |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 3.2**    |       | Certificate of Amendment of Second Restated Certificate  of Incorporation of Clayton Williams Energy, Inc., filed as Exhibit 3.1 to  our Form 10-Q for the period ended September 30, 2000                                                                                                                                                                                                                                                                                                                                                                            |
|     |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 3.3**    |       | Bylaws of the Company, filed as Exhibit 3.4 to our  Form S-1 Registration Statement, Commission File No. 33-43350                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
|     |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 3.4**    |       | Corporate Bylaws of Clayton Williams Energy, Inc.,  as amended, filed as Exhibit 3.1 to our Current Report on Form 8-K filed  with the Commission on June 1, 2005††                                                                                                                                                                                                                                                                                                                                                                                    |
|     |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 4.1**    |       | Indenture, dated July 20, 2005, among Clayton  Williams Energy, Inc., the Subsidiary Guarantors and Wells Fargo Bank,  National Association, as Trustee, filed as Exhibit 4.1 to our Current  Report on Form 8-K filed with the Commission on July 22, 2005†† 4.2** Registration Rights Agreement  dated July 20, 2005, among Clayton Williams Energy, Inc., the Subsidiary  Guarantors and J.P. Morgan Securities Inc., filed as Exhibit 4.2 to our  Current Report on Form 8-K filed with the Commission on July 22, 2005†† |
|     |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.1**   |       | Third Amendment to Amended and Restated Credit  Agreement, dated June 30, 2006, filed as Exhibit 10.1 to our Current  Report on Form 8-K filed with the Commission on July 14, 2006††                                                                                                                                                                                                                                                                                                                                                        |
|     |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.2**   |       | Participation Agreement relating to South Louisiana  IV dated August 2, 2006, filed as Exhibit 10.1 to our Current Report on  Form 8-K filed with the Commission on August 7, 2006††                                                                                                                                                                                                                                                                                                                                                         |

 

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| 10.3** |   | Participation Agreement relating to North Louisiana  — Hosston/Cotton Valley dated August 2, 2006, filed as Exhibit 10.2 to  our Current Report on Form 8-K filed with the Commission on  August 7, 2006†† |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                     |
| 10.4** |   | Participation Agreement relating to North Louisiana  — Bossier dated August 2, 2006, filed as Exhibit 10.3 to our Current  Report on Form 8-K filed with the Commission on August 7, 2006††                |
|   |   |                                                                                                                                                                                                                                     |
| 31.1*  |   | Certification by the President and Chief Executive  Officer of the Company pursuant to Rule 13(a) - 14(a) of the  Securities Exchange Act of 1934                                                                              |
|   |   |                                                                                                                                                                                                                                     |
| 31.2*  |   | Certification by the Chief Financial Officer of the  Company pursuant to Rule 13(a) - 14(a) of the Securities  Exchange Act of 1934                                                                                            |
|   |   |                                                                                                                                                                                                                                     |
| 32*    |   | Certifications by the Chief Executive Officer and  Chief Financial Officer of the Company pursuant to  18 U.S.C. § 1350                                                                                              |

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*                    Filedherewith

**             Incorporatedby reference to the filing indicated

†                     Identifiesan Exhibit that consists of or includes a management contract or compensatoryplan or arrangement

††               Filedunder our Commission File No. 001-10924

 

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**CLAYTON WILLIAMSENERGY, INC.SIGNATURES**

Pursuant to the requirements of the Securities Exchange Act of 1934, theRegistrant has duly caused this report to be signed on its behalf by theundersigned thereto duly authorized.
|        |             |   | **CLAYTON WILLIAMS ENERGY, INC.**                     |
|--------|------------------|--------|-------------------------------------------------------|
|   |             |   | * *                                              |   | * * | * * |
| Date:  | November 9, 2006 | By:    | */s/ L. Paul Latham*                                  |
|   |             |   | L. Paul Latham                                        |   |   |   |
|   |             |   | Executive Vice  President and Chief Operating Officer |   |   |
|   |             |   |                                                  |   |   |   |
|   |             |   | * *                                              |   | * * | * * |
|   |             |   | * *                                              |   | * * | * * |
|   |             |   | * *                                              |   | * * | * * |
|   |             |   | * *                                              |   | * * | * * |
| Date:  | November 9, 2006 | By:    | */s/ Mel G. Riggs*                                    |
|   |             |   | Mel G. Riggs                                          |   |   |   |
|   |             |   | Senior Vice  President and Chief Financial Officer    |   |
|   |             |   |                                                  |

 

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